In my two earlier posts, I had commented on the interest rate decision and on the RBI Monetary Policy Report. In this post, I want to comment on the liquidity enhancement measures that the central bank had taken.
To understand the liquidity-enhancement measures that the RBI took, read this excellent comment by Tamal Bandyopadhyay. My friend R. Jagannathan (‘Jaggi’) cheekily called it QE1. It is true that when the central bank announces its intention to bring down the liquidity deficit from 1% of Net Demand and Time Liabilities (NDTL) to a neutral level, it would mean asset purchase from commercial banks in return for cash. That is QE, technically.
[Note, however, that the central bank cannot bring this deficit down in a short time frame. That would mean too much of liquidity in the short run. Tamal notes that it might take as much as two years. Also, note that the aim is to bring the average liquidity deficit to zero. Not necessarily every day. The system could be in deficit on some days. In that sense, the Repo Rate will be operative.
Only when the system is never in a liquidity shortage, will the Repo rate cease to be the reference rate for cost of funds for the banks. It would become the Reverse Repo rate. There won’t be any interest rate corridor. Only one rate would matter. If the system is so adequately flooded with liquidity, effectively it means that the central bank has cut interest rates very aggressively. But, we are a long way off from that.
In another aside, since eliminating the liquidity deficit to zero might take two years, Tamal makes a very thoughtful point that, in effect, RBI has promised easy monetary policy for two years!]
But, it is not quite so. In that sense, all central banks engage in asset purchase and sale when they engage in Open Market Operations (OMO). They are always buying assets from and selling assets to commercial banks. That is done to steer the overnight borrowing rate closer to the policy rate. It is not done in lieu of interest rate policy.
What distinguishes QE from normal OMO is its duration (for how long?) and quantum (how much of asset buying is involved?). I would add that QE is distinct from normal OMO in the sense that it is used when conventional monetary policy tool – the interest rate – is no longer usable. That is, rates are at 0.0%. Of course, these days, central banks are going negative! So, the question is whether they should be doing QE at all, if they can go negative on rates.
Well, for effect, the central bank can offer funds to banks at negative rates (paying banks to borrow!) and buying assets to influence interest rates at all maturities and at all risk profiles! Whether it has any effect on the real economy or not is a different matter, altogether. RBI does not believe it has. Read the comment it had on western monetary policies in the box in the closing pages of its monetary policy report:
Although the overall objective has been to raise economic growth and counter deflationary conditions by deterring saving, and encouraging borrowing and risk taking, scepticism has developed about the efficacy of the policy in achieving anything beyond inflating asset prices and depreciating currencies competitively.
RBI is dead right.