Estimate of the ‘shadow policy rate’ for India


The severity of the pandemic shock to the economy has forced the Reserve Bank of India to rely heavily on non-standard measures to provide additional housing beyond conventional policy.

A menu of such measures, including long-term repo transactions, targeted LTROs, twist transactions, government bond purchases and the government securities acquisition program, were tested. The difference was that in India these measures were taken while we were still far from the lower bound of zero, generally defined as the moment when key rates fall to zero.

Even though the repo rate was lowered to 4%, below the low of 4.75% after the global financial crisis, the RBI was not prepared for the compromises associated with a lower policy rate. And so, it took non-standard measurements.

Did the impact of these nonetheless accumulate until significant easing?

Mapping the impact of unconventional measures in terms of policy rate easing is an exercise characterized by large margins of error. However, such exercises have been conducted in developed markets and we are borrowing a construct from those economies to understand the impact of the RBI’s unconventional measures.

First, by extending our proprietary index of financial conditions I-Sec PD (I-Sec PD FCI), we construct a monetary policy index, which is a weighted average of three variables closely related to monetary policy:

  1. Pension rate

  2. RBI Liquidity Adjustment Facility Net Deposits (to measure liquidity easing)

  3. Spread between the day-to-day weighted average rate and the repo rate (to measure the impact of “stealth easing”).

As you would expect, the MPI fell, suggesting further accommodation measures, even though key rates remained stable for more than a year.

Next, we use the monetary policy index to calculate the “realized effective repo rate”. This is done by identifying the level of pension rate fixing required to achieve conditions similar to those reflected by the monetary policy index, while keeping the other two variables constant in line with the averages during the normal period before. -crisis.

Stealth Easing Vs. The Impact of Liquidity

The above rate needs to be deepened if one is to judge the impact of liquidity easing measures alone. This is because India operates under a corridor rate system, the rate of which is the repo rate and the repo rate. While the first is the benchmark policy rate, the second becomes the effective policy rate when there is excess liquidity.

During the Covid-19 crisis, the RBI carried out a “stealth easing” by first reducing the reverse repo rate more sharply (which becomes the effective rate in the event of excess liquidity), then by allowing to the day-to-day weighted average rate to decline further. below this lower bound.

We want to quantify this stealthy easing, in order to further assess the impact of liquidity measures alone.

Accordingly, we subtract the difference between the weighted average overnight rate and the reverse repo rate (which is the component of stealth easing) from the realized effective policy rate calculated above.

After these adjustments, we arrive at a rate of 0.2%, which we call the “shadow policy rate” for the month of August.

It is also useful to compare the realized effective policy rate and the notional policy rate in a historical context. While the former is in line with the post-global financial crisis period, the latter is much lower in the current cycle. Such a result, in turn, reflects the fact that liquidity taps were more widely opened in the current crisis, while stealth easing was more prevalent in the previous cycle.

At its peak, the liquidity absorbed by the RBI’s Liquidity Adjustment Facility during the global financial crisis was just above 4% of deposits, compared to 5% today. This will likely increase further, as record government cash balances could unwind over the next few months and add to the cash surplus.

This time around, the excess liquidity also looks set to persist longer given the high level of government deficits, implying that the RBI has its work cut out for it when trying to normalize its policy.

It is precisely because the true accommodation of unconventional monetary policy is so important that the probability of an accident is high, if normalization is carried out without planning and preparation of the markets.

We are not arguing that the solution is to delay any normalization, but rather that a large gap between the policy rate and the repo rate cannot be closed quickly, but only in small steps.

The first step in this process would be to stop the active injection of liquidity. However, the liquidity easing undertaken by the RBI is largely unplanned, unlike the case of central banks in developed markets pursuing quantitative easing or QE. This is in part a consequence of the “impossible trilemma”. A large current account surplus (or zero current account), an overvalued real effective exchange rate, and large capital flows necessitated heavy intervention in the foreign exchange markets.

That is, while the RBI’s interventions in the bond market have been significant, they have been comfortably overwhelmed by currency purchases, viewed through the prism of easing liquidity. This situation may persist.

While RBI may not be able to refrain from forex intervention, it must actively sterilize the same. A short-term solution is to intervene via the futures market, but a more sustainable solution must be found in the medium term.

There are no such complications on stopping outright bond buying. The recent decision to link the G-SAP operation to the sale of short-term securities is one indicator and we expect the RBI to undertake liquidity neutral transactions in the bond market until the second. semester.

In the chain of events, the next simultaneous step would be to shift much of the liquidity absorption to floating rate reverse repo auctions instead of fixed rate auctions. Again, this has been evident over the past few weeks and should continue.

Such a mix of liquidity absorption will help the RBI to lower the interest rate corridor and limit any stealthy easing.

The final step in normalization will have to be through increases in reverse repurchase agreements. When RBI narrows the hallway to 25 basis points, much of the stealth easing would be undone. With the first two steps already underway, the last step cannot be too far.

The key idea of ​​our sequence is that active absorption of liquidity should not be part of the early stages of normalization. It is for this reason that central banks in developed markets, like the US Federal Reserve, do not consider outright asset sales to shrink balance sheets until well after the rate hike has started.

Otherwise, the switch from a fictitious policy rate or a low effective policy rate to the policy rate would be brutal and could lead to financial accidents.

Measures of “realized effective policy rate” and “shadow policy rate” help compare the amount of total monetary policy easing.

While the effective policy rate, i.e. the repo rate, was reduced by 155 basis points during the pandemic, the total accommodation estimated based on the decline in the real effective policy rate is 2.5 times that value, to 390 basis points.

The comparative analysis not only helps to understand the extent of the easing, but also the need to sequence the exit from emergency monetary policy to normal monetary policy, and its timing.

As the downside risks to growth dissipate with the progress of immunization, core inflation remains high, and the external environment appears poised to become less favorable, it is important that the RBI skillfully calibrates policy. monetary policy to avoid the risk of falling back on the curve as in the post-global financial crisis. years of crisis.

A Prasanna is Head of Research at ICICI Securities PD. Abhishek Upadhyay is Senior Economist at ICICI Securities PD.

The opinions expressed here are those of the authors and do not necessarily represent those of BloombergQuint or its editorial team.

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