RBI to make repo rate the operating policy rate; signals gradual tapering of liquidity

RBI to make repo rate the operating policy rate; signals gradual tapering of liquidity

Gone are the days when policy makers talked in riddles and habitually surprised markets using “shock and awe” tactics. Former Fed Chairman Alan Greenspan once said in a lighter vein, “Since I’ve become a central banker, I have learned to mumble with great incoherence, if I seem unduly clear to you, you must have misunderstood what I said”. Since then, central bank communication has evolved significantly. Policymakers, including RBI, now use forward guidance as a communication tool to nudge markets and further their objectives.

RBI in October MPC has begun to fine-tune excess policy accommodation. In doing so, it has struck a difficult conversation with markets. Taking away any policy support from markets is akin to taking a cookie away from a child. Neither the child nor the guardian takes pleasure in the process, and in all fairness, even the cookie seller stands to lose. In other words, in absence of nuanced communication, even lessening of existing accommodation can elicit strong withdrawal symptoms from markets, similar to what we experienced during “Taper Tantrum”.

That is because Efficient Markets take it upon themselves to weave into today’s asset prices all future possibilities. In that process, markets often amplify price reaction to every small Central Bank signal. During times of high uncertainty such sharp market moves, if any, may in turn have adverse consequences for the real economy, working contrary to Central Bank’s intentions. Thus as we gradually emerge out from the pandemic-era stimulus, the RBI will have to manage market overreaction as well as the real economy.