RBI deputy governor flags concerns over liquidity overhang

In the minutes of the Monetary Policy Committee's (MPCs) latest meeting that was released on Thursday, the deputy governor of the Reserve Bank of India (RBI), Michael Debabrata Patra, emphasised the growing liquidity overhang in the Indian banking system and its potential to pose a direct threat to both the inflation target and financial stability.

Patra, during the meeting, stressed the importance of addressing the excess liquidity issue, stating that "Withdrawal of excess liquidity should engage primacy in the attention of the RBI going forward as it presents a direct threat to the RBI/MPC resolve to align India’s inflation with the target, besides the potential risks to financial stability."

The liquidity situation in the banking system has seen significant changes in recent months, particularly after the central bank's decision to withdraw Rs 2,000 currency notes from circulation. This move led to an increase in liquidity due to deposits and the exchange of these notes. The RBI announced the withdrawal of the Rs 2,000 currency bills from circulation on May 19.

Patra also emphasised that the central bank should prioritise the withdrawal of excess liquidity from the banking system to mitigate the risks associated with inflation and financial stability.

In the broader economic context, Patra noted that the Indian economy was experiencing moderate growth as the effects of the pandemic waned. The output gap had closed, and corporate profitability remained strong despite a slowdown in top-line growth. Credit conditions in the financial sector were robust, although the cost of funds was tightening. Furthermore, there was a noticeable shift in consumer spending patterns toward services.

However, concerns regarding inflation have arisen due to recent spikes in food, metal, and energy prices, influenced by international factors such as geopolitical tensions and local supply shocks. Patra highlighted the uncertainty surrounding India's monsoon season and its impact on food prices, further complicating the inflation outlook.

Despite significant progress in reducing inflation from 7.8 per cent in April 2022 to 4.8 per cent in June 2023, Patra noted that sporadic supply shocks were now challenging the gains made in stabilizing output. These supply shocks were raising general price levels, affecting households' perceptions of inflation, and potentially spilling over into core inflation.

Given these concerns, Patra advocated for maintaining the status quo on the policy rate and continuing with the withdrawal of monetary policy accommodation. This approach, he argued, was essential to achieving the MPC's objective of bringing inflation down to the target and ensuring the sustained easing of core inflation.

Deputy governor Patra's remarks underscore the significance of addressing the liquidity overhang in the banking system as a crucial step in maintaining India's inflation target and financial stability amid a complex economic landscape marked by both domestic and international challenges.