Rising inflation? Bonds can be an answer!

Excess liquidity in the economy has always been considered bad since a long time. But why? Excess liquidity means more money is circulating in the economy than what is required. You would have heard the phrase, "Too much money chasing too few goods", and that, in fact, will be the effect of excess liquidity. Since more money is available, people demand more, and companies are not able to meet the demand. This is called Demand-pull inflation.

Interest rates have been a key tool to control inflation and in the circulation of money in the economy for a long time. Whenever the central bank notices excess liquidity (excess money flow) in the market, it increases the repo rate and other statutory reserve ratios. This lowers the amount lent by commercial banks and also forces them to increase the interest rates on the money lent, thus decreasing the liquidity or money circulation in the economy.

But how can government control inflation in trying times like a pandemic? The answer is through bonds. Today in this article, we are going to look at how government uses bonds to decrease money circulation in the economy.

Whenever the government and the central bank feel that excess liquidity is present in the economy, and there are expectations of inflation rates to go up, the RBI issues bonds to control this excess liquidity. How does this exactly work? Let me explain in simple words.

Whenever more money is circulating in the economy, the government will issue bonds with attractive interest rates and tax-free status to attract investors. As the interest rates are attractive and investing in government bonds is considered a safe investment, many investors flock in to invest in these bonds.

When the bonds are issued, a significant portion of the money that is in circulation is pulled out and results in a decrease in liquidity and inflation rates. This way the government gets to reduce inflation and investors also get an opportunity to invest in a safe avenue. It's a win-win situation overall! This process is called the Market Stabilisation Scheme (MSS) and the bonds are called Market Stabilisation Bonds (MSB).

But why does the government not use this more often? Because issuing bonds is basically accumulating debt. Whenever the central bank issues MSBs, the government's debt obligation increases. Due to this reason, MSS is not used as frequently as interest rates to control inflation. The government cannot spend this money too, it just has to maintain it with the central bank.

The RBI used MSS to decrease liquidity during the demonetisation in 2016. As more and more deposits were received by banks due to demonetisation of Rs 500 and Rs 1,000 notes, liquidity increased. The RBI initially asked banks to maintain a higher cash reserve ratio, but it added to their cost as they had to pay interest on it. So the RBI issued MSBs to banks to control the liquidity.

The most notable use of MSS in India was in 2002, when it was introduced. During that period, India witnessed a huge inflow of foreign capital and the inflation rate increased to 9 per cent. The RBI had no other options except for issuing MSBs. It managed to decrease the money circulation in the economy by Rs 2.5 lakh crore over the years which decreased the inflation rate to 7 per cent.

Whenever the government is trying to push out bonds in the market or, is bullish on bonds, remember that there are chances of inflation being high and the government using bonds as an instrument to combat inflation.

Also read:

Which is the right tool to fight inflation? Equity or fixed deposits?

The inflation monster is destroying your wealth every year!

Strange ideas about inflation

This article was originally published on February 14, 2022.