RBI is faced with a 'trilemma' as economy shrinks, inflation rises

As rising inflation mainly on account of food prices prevents any rate cut, the Reserve Bank of India is faced with a problem that is known as the ‘trilemma’, which has been preventing it from cutting interest rate in the previous two monetary policy that is needed to revive the economy. 

The ‘trilemma’ is to figure out how to manage the monetary policy’s independence without affecting the currency and the inflow of capital from abroad when the inflation is much above the centra banks’ comfort zone of 4-6 per cent mainly due to disruptions in the supply chain caused by COVID and increasing food prices.

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It cannot afford to cut interest rates too much because that would then result in a flight of capital from the country to assets or countries  giving better risk-reward. This will weaken the rupee against the dollar. On the other hand, if it raises rates to control inflation, then foreign capital will gush in due to the higher returns, which would make exports costlier. 

The central bank has been wary of cutting interest rates despite GDP growth falling by record levels in the quarters affected by coronavirus and the economy expected to shrink over 10 per cent for the year ended March 2021. That is because inflation remains high above the higher band of 6 per cent targeted by the RBI’s monetary policy framework.

In the recent past, the RBI has chosen to let the rupee strengthen. The currency has appreciated about 4% after falling to a record 76.9088 against the dollar in April. 

The stimulus package announced in the US has resulted in flow of capital into riskier assets like emerging markets, including India, which has resulted in the local currencies appreciating. As the rupee gained strength, exports that were already wavering got hit further.    

“Within the trinity, we believe the RBI has clearly chosen to let the currency appreciate,” said Rahul Bajoria, senior India economist at Barclays in Mumbai. “This would mean that in order to support economic revival, RBI may need to keep large amounts of liquidity, even if it raises latent inflation risks down the road. That also keeps alive the spectre of rapid reversal of policies in the future,” he said, reported Bloomberg.

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The RBI’s challenges are confounded by the yield curve. As inflation rises and capital from the US stimulus seek high-yielding assets, investors fear the yields in India will only rise. The central bank has resorted to open market operations, including buying state government bonds, to keep the yield under control.   

The RBI’s OMOs are, however, increasing liquidity available to banks already facing the problem of low appetite for credit. 

“This is problematic at a time when liquidity levels are already exceptionally high, inflation has crossed the upper limit of 6% for more than three quarters, core inflation remains high and sticky and inflation expectations remain elevated,” said Rajeswari Sengupta, assistant professor at the Indira Gandhi Institute of Development Research, Mumbai, Bloomberg reported.