The Reserve Bank of India has sent a message on its currency policy at the time where everyone is focused on interest rates and how the banker to the government is fighting a spike in bond yields. It can’t be holding the `impossible trinity’ anymore. It will be a turning point in policy tools. It was noted that the central bank has slipped in a message that it is worried about inflation and it won’t hesitate to use measures other than interest rates against price pressures.
The RBI said that the recent appreciation of the rupee is working towards imported inflationary pressures, which was lead by measures to contain the bond market volatility. When the central bank openly accepts that currency appreciation is helping achieve one of its important goals of inflation management and also an acknowledgement that the objective of currency operations has evolved beyond just tempering the volatility. Due to Covid-19, they cannot raise interest rates to fight inflation. So, it has found a tool in currency.
According to the Monetary Policy Committee, inflation has been above the target prescribed by law. As per the price pressures, the market has been demanding that interest rates be pushed higher. With yields increasing more than 30 basis points in a matter of days, it is very difficult to even for a central bank. A basis point is 0.01 per cent point. The RBI has so far been adopting the capital flows to prevent the appreciation of the currency, taking foreign exchange reserves to a record high which the Bank of America forecasts to touch 550 billion dollars.
The Rupee has appreciated 3.6 per cent this fiscal despite RBI’s dollar purchases. In June quarter, the RBI net bought $14.2 billion. Foreign exchange reserves are near a record at $537.5 billion, up to $108 billion from a year earlier. As the RBI battled to keep exports competitive by preventing a sharp Rupee appreciation, it let more Rupees into the system fuelling inflation, which is also being caused by the dislocation in supply chains. Inflation is becoming a threat and that easy monetary policy cannot be reversed soon killing a potential recovery even before it begins so the options for the central bank are very limited.
India needs capital so can’t stop it. RBI can’t increase the cost of funds stalling a nascent recovery. It could be compromised without provoking a public outrage is currency management. It is easier to manage the optics when it is appreciating so, it would be a support for currency appreciation as the Greenback flows in.
