Muddled incentives can muddy RBI’s monetary policy objectives

livemint.com:

RBI) also uses a package of explicit and implicit incentives to persuade economic agents to act in a certain fashion so that the central bank can meet its price, economic growth and financial stability mandates. Unfortunately, the incentives embedded in the current version of monetary policy as well as in the banking regulatory framework seem to be sending out mixed signals.

RBI actually uses a mix of incentives, moral suasion and direct intervention if it wants economic agents to translate monetary signals to the real economy. In the earlier era of central banking by fiat, banks had to compulsorily comply with RBI-issued edicts; they had little room for deviant behaviour.

But, post the 1991 economic reforms, RBI also had to re-adjust and deploy a wider range of indirect instruments and incentives, reserving the sledgehammer approach for exceptional circumstances. The central bank is today confronted with the consequences of two sets of incentives that are sending out mixed signals, one that was highlighted during the August monetary policy meeting and another which found reference during the post-policy press conference, and was the focus of some recent discussions in Parliament.

In the first instance, misplaced incentives have seemingly forced the central bank to resort to a battering-ram approach for managing surplus liquidity in the system. The recent surge in systemic liquidity—prompted by withdrawal of the ₹2,000 note and aided by government spending, RBI’s annual surplus transfer to the government and capital inflows—adds fuel to existing inflationary tendencies currently under pressure from elevated food prices.