RBI’s expansionary policy and challenge of the impossible trinity

Synopsis: RBI need to exit out of its expansionary policy and manage ‘the impossible trinity’, i.e. Capital inflow, inflation and exchange rate.

Source: The Hindu   

Introduction 

• • RBI adopted the extraordinary expansionary policy after Covid-19.  

• • It reduced policy interest rates aggressively to increase the liquidity in the market. It also provided targeted assistance to especially distressed sectors. 
  • But, now RBI should consider an exit plan out of expansionary policy to avoid any loss in the macroeconomic terms. 
  • In this process RBI might face the challenge of managing ‘the impossible trinity’, i.e.  Keeping doors open for capital flows while simultaneously maintaining a stable exchange rate and restraining inflation. 

What are the challenges in managing ‘the impossible trinity’? 

Firstly, RBI need might face a dilemma of managing Inflation and support to economic recovery.  

• • Inflation is above the RBI’s target band for the past several months and is expected to remain above target for the next several months.  
  • Whereas, MPC is not able to decide against the expansionary monetary policy, out of concerns for growth and financial stability.  
  • MPC expects inflation to soften by itself due to bumper winter crop and normalisation of supply chain post-lockdown.  

Second, RBI needs to think about the savers, offered low-interest rates at a time of high inflation. Thus, the value of their saving is getting reduced.  

Third, RBI require to withdraw the ‘excess’ liquidity from the market.  

• • Banks are routinely depositing trillions of rupees with the RBI is evidence that the liquidity increase by RBI is not giving the intended results.   
  • Mispricing of risk of too much liquidity for too long can lead to the financial crisis.  

Fourth, RBI might face the challenge of ‘taper tantrums’ at the later stage, which triggers the panic sell-off by the investors in the market.  

• • Taper tantrum: In May 2013, U.S. Federal Reserve Chairmen announced that they were considering gradually tapering/reducing ‘quantitative easing’.  
  • Although the announcement should have been taken as signs of a robust recovery in the economy, instead panic sell-off started in the financial market.  

• Thus, RBI also need to frame their communication strategy in a way that it doesn’t trigger the panic sell-off.  

Fifth, RBI will have to stop the rupee from appreciating, in the face of policy change.  

• • Current Account Surplus this year together with massive capital flows has caused increase in flow of dollar in the system.  
  • It is putting the upward pressure on the Rupee, which is already overvalued in the real terms.  
  • RBI has already absorbed this year, nearly $90 billion to prevent exchange rate appreciation and to maintain the competitiveness of the rupee.  

• • Thus, RBI’s ability to keep the Rupee value in control will be constrained by increasing inflation.  

In the upcoming days, managing the impossible trinity will be a tricky challenge for RBI given the condition of the economy after COVID-19.

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