– Dr Duvvuri Subbarao, Governor of the RBI 2008-2013
The behavior of central banks has undergone a radical change after Covid. While they have been extremely growth friendly in response to the pandemic shock, they have also become tolerant of above target ‘transient’ inflation, leading to a recalibration of their own targeting framework. inflation in some cases. The emphasis on this narrative deterred forward-looking financial markets from evaluating central bank actions too early.
The repeated emphasis that inflation is transient has led to a sort of Pavlovian conditioning of bond markets. As headline inflation continues to far exceed central bank targets, markets are uncertain whether and to what extent central banks will respond to the ongoing inflationary dynamic. Bond markets, in other words, have become accustomed to not making any inflation-induced yield curve adjustment without supporting central bank guidance.
But as we move past Covid, we find little respite from the sharp build-up in inflationary pressures. Commodity prices remain high, shipping rates remain at record highs, and even labor costs are on the rise. As a result, markets are turning to central banks again for advice. When will central banks signal the end of the Covid era? How long can inflation remain transient before it is no longer so? Where is the fine line between standardization and tightening? Which of the two, growth or inflation, will determine the reaction function of central banks in the future?
As the current macro environment puts pressure on RBI to reduce the size of the pandemic-driven stimulus, the path to normalization is expected to be very gradual and non-disruptive. RBI must therefore address the challenges of avoiding any overreaction of the market to the standardization of hosting in the Covid era.
In the next RBI monetary policy, therefore, we expect the MPC to keep rates and policy unchanged. We also expect RBI to communicate its intention to normalize the liquidity of the banking system by providing direction based on time and quantum. While emphasizing the need for sustainable growth, the RBI can recognize the rigidity of core inflation. In doing so, it can pass the baton of growth over to the government, which has the budgetary means to tackle growth more directly at this stage.
In summary, we expect the RBI to signal an end to over-accommodating the pandemic and underline its intention to maintain what would still be accommodative monetary policy.
(Churchil Bhatt is Executive Vice President for Debt Investments at Kotak Mahindra Life Insurance Company. The opinions are his)