Balancing price stability and financial stability in current scenario

25 Oct 2023 , 09:39 AM

Understanding price stability versus financial stability

For most parts, they typically imply the same thing. Price stability is all about the central bank of managing inflation. Price stability is about keeping inflation at a level that is conducive to growth. Some inflation is necessary for any economy and we saw the Japanese stagnation in the two decades post 1990, when they had virtually zero inflation and growth was just not happening. The other extreme is when inflation starts going up and that has repercussions for inflation expectations, purchasing power and interest rates. Sharply higher inflation results in higher interest rates and higher cost of funds. This tends to impact the cost of capital and depresses valuations of equity too. But, what is stability. 

Financial stability essentially entails 4 things. Firstly, financial stability entails that valuation pressures are controlled. That means asset prices should not be substantially higher than economic fundamentals. Secondly, financial stability entails that households are not under excessive leverage. When high debt leads to spending cuts, it results in fall in demand and impacts economic activity. Thirdly, financial stability also entails that banks and financials are not overleveraged or exposed to bad assets. That can impact credit flow in the economy. Lastly, financial stability is also about ensuring that there is no run on assets; either on banks or in the equity and debt markets. A quick reading would tell you that financial stability and price stability are largely related. It is only when they tend to be off balance that the RBI has to intervene. That was the gist of the speech delivered by the RBI governor, Shaktikanta Das, recently at the Institute of Economic Growth (IEG).

Demystifying the current global scenario

As Das rightly pointed out in his address to the IEG, any discussion of financial stability versus price stability has to begin with the global scenario, since a large chunk of the prices risks and financial risks in India could arise from global factors. According to Das, there are 3 distinct changes that are happening in the global scenario today, with larger implications for the Indian economy.

1. Inflation is moderating slowly and that is also being routinely interrupted by shocks in the system.

    

2. Growth, despite what the GDP numbers may say, is slowing at a global level; and that is most prominent in the extent and quality of consumer spending.

    

3. Thirdly, there are lurking risks of financial instability since most central banks have raised rates to the extent possible and are now sitting on a possible landmine of fall in investment value, if marked to market.

The result is that, due to global financial markets being in a state of flux, the financial markets have become highly sensitive to every piece of new information. This has made policymaking overtly complex since it is almost like a multiple regression of factors that is impacting the growth and inflation variables. 

Stability dilemma: Global experience, 2008 versus 2023

A classic case of financial shock in the current scenario is the simultaneous rise in 3 critical variables. Crude oil prices have risen 35% in the last 3 months, US bond yields at near 5% are at a 17 year high and the US dollar index is nearing the 107 mark, a level it has crossed only thrice in the last 40 years. This has added an additional dimension of policy dilemma for central banks across the world.

Das has highlighted that in such a situation, conflicts between financial stability needs and price stability needs may be at cross purposes. For instance, high bond yields are indicative of stress on balance sheets of corporates and a fall in spending. In this situation, even if inflation is high, the central banks have to be cautious about persisting with rate hikes. That is what the RBI has done and that is what even the Fed is now doing by shifting its tune to a longer pause. Similarly, for a country like India with a strong import intensive component, a weak rupee means imported inflation. That would make any domestic efforts to control inflation by raising rates pointless. Thes are the kind of dichotomies that the central banks have to deal with in the current global scenario.

Such policy trade-offs are nothing new for central banks in the world. For instance ,during the global financial crisis of 2008 and 2009, the central banks globally undertook large scale monetary stimulus to depress interest rates to ultra-low levels and rekindle growth. The sole idea, back then, was to restore financial stability in the near term, but ended up threatening future price stability. However, that was a trade-off that most central banks knowingly and willing took on. It needs no reiteration that the large scale monetary and fiscal stimulus undertaken to address the global financial crisis (GFC) in 2008, actually sowed the seeds of inflationary pressures in subsequent years; including the latest inflation spike post 2020.

Now in 2023, the central banks once again face a trade-off between price stability and financial stability. In 2020, during the COVID crisis, the world once again went on a loosening spree and the liquidity glut, combined with supply chain bottlenecks, triggered the runaway inflation of today. Central banks, in response, have resorted to unprecedented rate hikes across the board. This resulted in large erosion in profitability of some banks in advanced economies; as was evident in the mini-banking crisis faced by the US earlier this year. These banks had not factored in the interest rate risks associated with a reversal of the accommodative policy stance. So, what is the moral of the global story? In recent times, we have witnessed multiple linkages between financial stability and price stability; and the cause-effect relationship runs both ways. At the end of the day, the impact of this dichotomy would lie in the policy choices made by the central banks.

India stability story from 2018 to 2022

In India, the RBI has the responsibility to maintain monetary stability and price stability; as well as the larger responsibility of maintaining financial stability. This is a natural role that falls on the RBI since it is also the regulator and supervisor of banks and other financial sector entities and markets. The former RBI governor Y Venugopal Reddy best explained Financial Stability in the Indian context; “Financial Stability refers to the smooth functioning of the financial markets and institutions. It does not mean absence or avoidance of crisis but presence of conditions conducive to efficient functioning without serious disruption.” This definition implies that the RBI and the government be adequately prepared to handle such situations since many of them are globally induced and the Indian policymakers may have little control or influence over the triggers. Here is a quick take on how the RBI has tweaked its policy focus when such a dichotomy between price stability and financial stability arose.

• The first such situation was in the second half of 2018 when the collapse of IL&FS virtually dried up liquidity for NBFCs. It entailed measures to intensify supervision of NBFCs, close monitoring of their liquidity and stability as well as infusing system liquidity through innovative instruments. The priority then was to restore market confidence through communication, backed up with actual action.

   

• In early 2020, the unprecedented COVID pandemic called for rapid business continuity measures. Repo rates were cut by 115 bps in two months, although India did not succumb to the temptation of zero interest rates. In addition, a massive liquidity infusion to the tune of 8.7% of GDP was also put out. To ensure stability, the liquidity was granularly targeted and had clear sunset clauses. 

   

• The year 2021 was when the RBI migrated surplus liquidity from the short end to the longer horizon through variable rate reverse repo (VRRR) auctions of longer tenors. This helped to lift the short-term rates from ultra-low levels, thereby obviating financial stability challenges. This was also the period when the RBI seriously started the flexible inflation targeting (FIT).

   

• Year 2022 saw a major challenge to financial stability in the light of the Russia Ukraine war. This impacted the supply chains of crude oil and other commodities from the Black Sea and the RBI had to quickly change tack to prioritising inflation over growth. The RBI also shifted the monetary policy stance from accommodative to withdrawal of accommodation. To make inflation control effective, the supply side shocks were also addressed with the government taking steps to temper the price impulses.

Circa 2023: Balancing financial and price stability in current context

There have been several complications that the RBI had to deal with in 2023; and the positive side was that India had already emerged as the fastest growing large economy among economies with GDP of over $1 trillion. After raising the policy repo rate by 250 bps cumulatively between May 2022 and February 2023, the RBI has maintained pause on policy rates since February 2023. The 250-bps hike is still transmitting through to the financial system and the RBI is confident that it would eventually inflation lower. Here, there is a delicate balancing act that the RBI had to do. Inflation control was non-negotiable, but growth was the big opportunity. The argument now appears to be that if the Indian economy can grow at 6.5% real GDP, amidst high inflation, the potential is huge going ahead. That explains such a prolonged pause, even in the midst of global hawkishness.

However, the RBI has simultaneously taken a broader approach to the idea of financial stability. It has adopted a prudent approach to revamp regulation and supervision of banks, NBFCs and other financial entities. Macro stress tests have already revealed that Indian banks and NBFCs are seeing sustained growth in NII, improved asset quality, adequate capital buffers and robust credit growth. This has been true across banks and NBFCs. In a sense, 2023 has been a year of reckoning when the RBI had to take a bold decision on rate pause; and for now, that seems to have worked quite well.

Final thoughts on price stability versus financial stability

In a sense, it has been observed that price stability (controlled inflation) is an anchor for financial stability. However, quite often, they can be (or at least appear to be) at cross purposes. That is when trade-offs are called for; and at times such a trade-off becomes rather close. The recent years have made the role of the central bank more challenging. They need to manage the complementarities and trade-offs as efficiently as possible. As Das sums up the answer to the debate; if price stability is a sacrosanct objective of growth; then financial stability is non-negotiable. Alan Greenspan had once famously said, “An environment of greater economic stability has been key to the impressive growth in much of the world.” That is the tightrope that the RBI has been trying to walk in 2023.