Limitations and contradictions in the functioning of RBI

• The Reserve Bank of India, along with the monetary policy committee, has undertaken measures to address the fallout of the COVID-19 pandemic.
• Their actions are guided by multiple considerations — inflation and growth management, debt management and currency management.
• These multiple considerations have inadvertently exposed the limitations of and the inherent contradictions in the central banking framework in India.

Monetary policy functions

• The MPC is guided by the goal of maintaining inflation at 4 plus/minus 2 per cent.
• In its August policy, despite dire growth prospects, MPC chose to maintain the status quo.
• This decision was driven by elevated inflation i.e. above 4 plus/minus 2 per cent. 
• This raises the question: At the current juncture, should the MPC be driven by growth considerations or should short-term inflation concerns dominate?

Understanding the nature of current inflation

• The current rise in inflation is driven by supply-chain dislocations owing to the lockdowns.
• This is evident from the growing disconnect between the wholesale and consumer price index.
• Since April, while WPI has been in negative territory, CPI has been elevated.
• The MPC’s mandate is to deliver stable inflation over long periods of time, not just a few months.
• Yet, it would appear as if it is more concerned about elevated inflation in the short run.
• Equally puzzling is the refusal of MPC to provide any firm projection of future inflation.

Manager of government debt

•  As manager of the government debt, the RBI is tasked with ensuring that the government’s borrowing programme sails through smoothly.
• To this end, it has carried out several rounds of interventions popularly known as operation twist.
• in operation twist government RBI intended pushing down long-term Gsec yields, and exerting upward pressure on short-term yields as a consequence.
• In doing so, the RBI ended up doing exactly the opposite of what the MPC was trying to achieve by cutting short term rates, well before it reached the lower limit of its conventional policy response.

3) RBI’s intervention in currency markets

• The RBI’s interventions in the currency market have constrained its ability to carry out open market operations as these would have led to further liquidity injections into the system.
• Put differently, its debt management functions have run up against its currency management functions.
• Underlining the complexity of all this is the talk of sterilisation — the opposite of injecting liquidity in the system.

Consider the question “RBI’s functions at the current juncture suffers from contradicting functions. Examine such contradictions in its role and suggest the ways to avoid such contradictions.”

Conclusion

The central bank must develop a clear strategy on what to do. At this juncture, there is a strong argument to look past the current spurt in inflation, and test the limits of both conventional and unconventional monetary policy. At the other end, while it may want to intervene to prevent the rupee’s appreciation, in doing so, it is constricting its debt management functions which will have its own set of consequences. There are no easy answers.

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