During the pandemic year more than a decade later, the West’s monetary spigots have been opened even more. A liquidity glut has ensued. The size of the Federal Reserve’s balance sheet has grown by seven times since its pre-Lehman days, which amounts to a compound annual growth rate of about 21% over a 12-year period. While the rate of monetary expansion over this period has been torrid, neither employment nor economic output grew by even a fraction of that rate.

Still, the US economy stayed afloat and stock markets rallied, while wealth inequality worsened. How does a central bank exit this chakravyuh, or maze? Any hint of reducing the rate of money expansion threatens to cause panic and burst the bubble it blew. Just a mention of the word ‘taper’, which means reducing the pace of money expansion, caused a big shock to the world economy in 2013. The shock was such that the T-word has got seared into the collective memory of global financial markets.

The Reserve Bank of India (RBI) too finds itself in a similar predicament, where the way out of its liquidity glut is hazy. By last August, RBI’s balance sheet had ballooned by more than 30% over the previous year, thanks to purchases of foreign exchange externally and of government bonds domestically. That pace has been sustained. RBI has injected liquidity through long-term repo operations, which essentially provide long-term money at low overnight rates.

The Indian central bank has also provided implicit liquidity support to mutual funds, which is like an Indian version of unorthodox monetary policy. It has not quite ventured into taking credit risk onto its books, nor has it signalled a readiness to buy toxic assets, but that day may not be far off when it is asked to defrost frozen credit markets. To enhance market liquidity through money infusion or through open market operations is nothing but money creation.

As a result of India’s liquidity glut, money is flowing in and out of the central bank to the tune of ₹7 trillion on a daily basis. This has resulted in an anomaly: market lending rates have gone below RBI’s reverse repo rate, which is supposed to be the de facto floor. Cheap money is an invitation to do foolish and risky things, which, if done widely and voluminously enough, can spell disaster for financial stability. So RBI has tentatively tried to nudge market rates higher by announcing a reverse repo auction. This is our own mild version of policy normalization (sans the dreaded T-word).

But the market reaction was one of panic all the same, and there was a spike in interest rates, causing the central bank to rethink its strategy. To calm nervous bond traders, the governor has categorically said that liquidity support will continue as long as necessary, but surely we need to plan an exit from the current glut?

Why not simply loan ₹5 trillion to the central government against shares of public sector undertakings, on a bilateral basis at a low rate of 3% for a period of five years to fund its huge deficit? That will bypass markets and not cause any disruption to interest rates. Whatever the way out of this whirlpool of liquidity, it’s not going to be easy.