Quantitative ‘tightening’ was always considered to be a tough job for the Federal Reserve once the Lehman crisis seemed to be behind us. After keeping interest rates close to zero for too long and pumping in funds by buying government securities, the Fed did everything possible to protect the system. During the pandemic, the preferred solution, once again, was to lower the interest rate and open the taps. The Reserve Bank of India too did everything possible to protect growth by lowering the repo rate. Rolling back the same was, however, always going to be a challenge.
In the US, the Fed has increased rates by 450 bps with the possibility of more rate hikes. The story of the Silicon Valley Bank (SVB) is relevant here because when a bank buys safe securities (when interest rates are low), it also means that their prices are high. Now, with the Fed raising rates, the prices have come down, and if a bank wants to sell bonds it holds, it will face financial loss. In this situation, are US treasuries safe or ‘toxic’? SVB had invested in treasuries on the assumption they were safe assets!
This is interesting because almost all countries hold their forex reserves partly in dollars. While the exact amount is not revealed, given the total stock of forex reserves in the world, one can guess that countries could be holding anything between 60-70% of their reserves in dollars. These reserves are normally used to sort out balance of payments. But if any country were to sell these securities to get dollars, they would have to sell at a loss in an era of rising interest rates. For example, the 10-years bond gave a yield of 1.51% in 2021 and now averages around 3.60% in 2023. Therefore, the value of such securities has gone down significantly over two years.
The second part of the story of ‘easing followed by tightening’ pertains to the targeted Fed rate. Bringing it to zero had a rationale. But when things normalise, what should the market expect the rate to be? Should it be 1% or 2% or 3%? This part of the picture is not yet painted.
Would the same apply to India? True, the repo rate has been increased from 4% to 6.5%, but the bond yields have been sticky and increased by just around 40-50bps. Therefore, while there would be a decline in the value of bonds that have to be revalued, the hit on the profit and loss account will be buffered to that extent. Further, given that these valuations are made every quarter, losses are booked along the way so that when the final sale is made, the shock is minimal.
But, the process of tightening has had an impact on the lending rates quite perceptibly, as ever since the external benchmark concept has come in, loans like those for housing have been linked to this benchmark. This worked in the borrower’s favour when the repo rate came down to 4%. Now, with an increase of 250 bps, the transmission is instantaneous and it is not surprising that such borrowers are unhappy.
The lesson at the country level is that very easy monetary policies should have a short time-frame and not be continued for a long period of time. This is so because when the unusual situation that led to low interest passes, customers are used to the teaser rates and expect the same to continue forever. And this can never happen. There is hence more pressure on the central bank from industry bodies as well as the government to lower the repo rate or not increase the repo rate, because the base rate of 4% is always at the back of the mind.
There should be signals to foretell that things will ‘mean revert’ in terms of policy rate. The question would be what would be this ‘mean’? Ideally, when the MPC rules of engagement were drafted—under which, inflation was targeted at 4+/-2%, there could have been some indication given on the normal repo rate in the form of a range as well. By not giving such a range, the normal repo rate is open to interpretation or conjecture. When the repo rate was lowered to 4%, it was known that this was an extraordinary measure. But, to now look at a normal repo rate at something above this mark would be logical.
Hence, what is necessary is to anchor the repo rate or the Fed rate to a normal. Data on repo shows that over the last 20 years before the pandemic (when it started at 4.4%), it was only in 2009-2010 that the policy rate was at 5%. A level of around 6% appears to be a fair value going by the median and mean. The Fed funds rate would average around 1.5%. But can the past be a good measure for looking at the future?
One way out would be to have an indicative real interest rate for the policy benchmark. There is again nothing sacrosanct about such a number, but talking of one can temper expectations. Hence, targetting a real repo rate of 1 or 1.5% will anchor expectations. If it is stated that a particular level of real interest rate is targeted, just like the inflation rate with the band, then it would be easier to anchor expectations in future. This will hence serve as signals of how the central bank may behave given the inflation trajectory.
Disclaimer: The author is the Chief economist at Bank of Baroda