Context
- Recently, the Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) hiked the repo rate by 35 basis points (bps) to 6.25 per cent with immediate effect.
- The RBI policy rate is now at its highest level since August 2018 and this is the fifth rate hike by the central bank in this financial year.
- In this context, this edition of the Burning Issue will talk about the Monetary policy of RBI, the tools used by it and its analysis.
What is monetary policy?
- Monetary policy is the macroeconomic policy laid down by the central bank. It involves the management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.
- Economic statistics such as GDP, the rate of inflation, and industry and sector-specific growth rates influence monetary policy strategy.
- A central bank may revise the interest rates it charges to loan money to the nation’s banks. As rates rise or fall, financial institutions adjust rates for their customers such as businesses or home buyers.
- Additionally, it may buy or sell government bonds, target foreign exchange rates, and revise the amount of cash that the banks are required to maintain as reserves.
Goals of Monetary Policy
- Control Inflation: Contractionary monetary policy is used to target a high level of inflation and reduce the level of money circulating in the economy.
- Reduce Unemployment: An expansionary monetary policy decreases unemployment as a higher money supply and attractive interest rates stimulate business activities and expansion of the job market.
- Manage Exchange Rates: The exchange rates between domestic and foreign currencies can be affected by monetary policy. With an increase in the money supply, the domestic currency becomes cheaper than its foreign exchange.
Types of Monetary Policy: Expansionary and contractionary
- Contractionary policy: A contractionary policy increases interest rates and limits the outstanding money supply to slow growth and decrease inflation, where the prices of goods and services in an economy rise and reduce the purchasing power of money.
- Expansionary policy: During times of slowdown or a recession, an expansionary policy grows economic activity. By lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase.
Monetary policy in India and the Role of RBI
- Aim of Monetary Policy: In India, the monetary policy of the Reserve Bank of India is aimed at managing the quantity of money to meet the requirements of different sectors of the economy and to increase the pace of economic growth.
- Tools of Monetary Policy: The RBI implements the monetary policy through open market operations, bank rate policy, reserve system, credit control policy, moral persuasion and through many other instruments. Using any of these instruments will lead to changes in the interest rate or the money supply in the economy.
- Types of Monetary policy: It can be expansionary and contractionary in nature. Increasing the money supply and reducing interest rates indicate an expansionary policy. The reverse of this is a contractionary monetary policy.
- For instance, liquidity is important for an economy to spur growth. To maintain liquidity, the RBI is dependent on the monetary policy. By purchasing bonds through open market operations, the RBI introduces money into the system and reduces the interest rate.
Monetary policy tools of RBI
[A] Quantitative tools
Bank Rate Policy
- The bank rate is the minimum rate at which the central bank of a country provides a loan to the commercial bank of the country.
- Bank rate is also called discount rate because the central bank provides finance to commercial banks by rediscounting bills.
- The RBI uses bank rate to control credit in the economy.
Open Market Operations
- OMO are another important instrument of credit control.
- OMO means the purchase and sale of securities by the RBI.
- For instance, in an inflationary scenario, the RBI will start selling government securities, the selling of securities will reduce the money supply from the system (Since the buyer of the securities will pay for them in Rupee, hence currency from the system goes out), reduction in money supply will lead to a reduction in funds with the commercial banks, which further reduce their lending capability. A fall in lending thus contracts credit in the economy.
Cash Reserve Ratio
- Banks in India are required to keep certain proportions of their deposits in the form of cash with themselves as reserves.
- If the legal CRR is 10%, then the bank will have to keep Rs 100 as reserves against the deposit of Rs 1000.
Liquidity Adjustment Facility
- LAF is a monetary policy instrument which allows commercial banks and primary dealers to borrow money through repurchase agreements or Repos/reverse repos.
- LAF is used to aid banks in adjusting day-to-day fluctuations in liquidity.
- RBI extends LAF facility only to commercial banks (excluding RRBs) and Primary dealers.
- LAF allowed banks to park their excess money with the RBI in case of excess liquidity or to avail liquidity from the RBI at the time of deficit on an overnight basis against the collateral of government securities.
Repo and reverse repo
- Repos or Repurchase Agreements is an instrument which allows banks to borrow money from the RBI to manage short-term needs of liquidity against the selling of government securities with an agreement to repurchase the same government securities at a predetermined date and rate. The rate at which the RBI lends to the banks is called Repo Rate.
- Reverse Repo is an instrument which allows the RBI to borrow from the banks by lending government securities. The rate at which the Banks lend to the RBI is called Reverse Repo Rate.
- Repo injects money into the system whereas Reverse Repo takes money out of the system.
- The RBI increases the Repo Rate during the time of inflation and decreases the Repo Rate during the time of deflation and low growth.
Marginal Standing Facility
- MSF is a new scheme announced by the RBI in the year 2011-12.
- MSF is a penal rate at which banks can borrow money from the RBI over and above what they can borrow from the RBI under the LAF window.
- MSF is a penal rate and is always fixed at a higher rate than the Repo rate.
- The MSF would be a penal rate for banks, and the banks can borrow funds by pledging government securities within the limits of the statutory liquidity ratio.
- The scheme has been introduced by RBI with the main aim of reducing volatility in the overnight lending rates in the inter-bank market and enabling smooth monetary transmission in the financial system.
Statutory Liquidity Ratio
- SLR is the percentage of the deposits that the banks have to hold with themselves in highly liquid government securities.
- SLR is one of the many arrows in the RBI’s monetary policy quiver. These are used, sometimes in isolation, sometimes in combination, to manage the money supply, interest rates and credit availability in the country.
- The SLR is an important tool of monetary policy, and its primary aim is to ensure that banks always have enough liquidity (cash and cash equivalent securities) to honour depositors’ demands and that they don’t lend away all their funds.
Bank Base Rate
- The Base Rate is the minimum interest rate of a bank below which it is not permissible to lend, except in some cases if allowed by the RBI.
- BR is the minimum interest rate that a bank must charge because below the base rate it is not viable for the bank to lend.
- The base rate, introduced with effect from 1st July 2011 by the Reserve Bank of India, is the new benchmark rate for lending operations of banks.
- Thus, all categories of domestic rupee loans should be priced only with reference to the Base Rate.
[B] Qualitative Measure of the RBI
Fixing Margin Requirements
- The margin refers to the “proportion of the loan amount which is not financed by the bank”. Or in other words, it is that part of a loan which a borrower has to raise in order to get finance for his purpose.
- For example, If the RBI feels that more credit supply should be allocated to the agriculture sector, then it will reduce the margin and even 85-90 per cent loan can be given.
Consumer Credit Regulation
- Under this method, consumer credit supply is regulated through hire-purchase and instalment sale of consumer goods. Under this method, the down payment, instalment amount, loan duration, etc., is fixed in advance. This can help in checking credit use and then inflation in a country.
Publicity
- This is yet another method of selective credit control. Through it, Central Bank (RBI) publishes various reports stating what is good and what is bad in the system. This published information can help commercial banks to direct credit supply in the desired sectors. Through its weekly and monthly bulletins, the information is made public, and banks can use it for attaining goals of monetary policy.
Credit Rationing
- Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount available for each commercial bank. This method controls even bill rediscounting. For certain purpose, the upper limit of credit can be fixed, and banks are told to stick to this limit. This can help in lowering banks credit exposure to unwanted sectors.
Moral Suasion
- It implies pressure exerted by the RBI on the Indian banking system without any strict action for compliance with the rules. It is a suggestion to banks. It helps in restraining credit during inflationary periods. Commercial banks are informed about the expectations of the central bank through monetary policy. Under moral suasion, central banks can issue directives, guidelines and suggestions for commercial banks regarding reducing credit supply for speculative purposes.
New Monetary Policy Framework: The MPC and Inflation Targeting
What is Monetary Policy Agreement?
- In 2015 The Government of India and the Reserve Bank of India signed a Monetary Policy Framework Agreement. The new monetary policy framework was formed following the recommendations of a committee headed by RBI Deputy Governor Urjit Patel.
- The objective of monetary policy framework is to primarily maintain price stability while keeping in mind the objective of growth.
- As per the agreement, RBI would set the policy interest rates and would aim to bring inflation below 6 per cent by January 2016 and within 4 per cent with a band of (+/-) 2 per cent for 2016-17 and all subsequent years.
- The central bank will be deemed to have missed its target if consumer inflation is at more than 6 percent or at less than 2 percent for three consecutive quarters starting in the 2015/16 fiscal year.
- If the central bank misses the inflation target, it will send a report to the government citing reasons and remedial actions.
- The central bank will also need to give an estimated time period within which it expects to return to the target level.
Significance of Monetary Policy Agreement
- While the agreement gives a free hand to the RBI Governor to decide on the monetary policy measures to achieve the inflation target, it also requires the RBI to give out to the Central Government a report in case the target is missed for some time. Thus, it is a fine balance between autonomy and accountability.
- The World over, the Central banks are moving towards an inflation targeting based criteria for managing monetary policy. The MPA is a step in that direction.
- The MPA will put India into the League of Nations that followed a rule-based monetary policy mechanism.
Monetary policy committee
- The monetary policy committee framework will replace the current system where the RBI governor and his internal team have complete control over monetary policy decisions. While a technical advisory committee advises the RBI on monetary policy decisions, the central bank is under no obligation to accept its recommendations.
- The committee will have six members, with three appointed by the Reserve Bank of India (RBI) and the remaining nominated by an external selection committee. The RBI governor will have the casting vote in case of a tie.
- According to the Finance Bill, the committee will consist of the RBI governor, the deputy governor in charge of monetary policy and one official nominated by the central bank.
- The other three members will be appointed by the central government through a search committee.
- This search committee will comprise the cabinet secretary, the secretary of the Department of Economic Affairs, the RBI governor and three experts in the field of economics or banking as nominated by the central government.
- The members of the MPC appointed by the search committee shall hold office for a period of four years and shall not be eligible for re-appointment.
- The idea to set up a monetary policy committee was mooted by an RBI-appointed committee led by deputy governor Urjit Patel in 2014.
Assessment of the Monetary Policy of RBI
Achievements
- The overall requirements of expanding economic activities have been met adequately.
- In respect of priority sectors, for example, the objective of providing 40 percent of the bank credit has been met.
- Again, the funding of several important development programmes for the weaker sections of the population has been reasonably satisfactory.
- Even in respect of the control of inflation, the monetary policy has fared well. Overall, inflation has remained in the desired bracket except in a few instances.
Failures
- The most unsatisfactory result has been in respect of the expansion of the money supply. The growth rate of money has been much more than the growth in real products.
- Another shortcoming lies in the allocation of funds to various areas of sectors. The imbalances in credit allocation are more pronounced when one considers agriculture and small industry on the one hand and the large, organised industry and service sector on the other.
- Agriculture continues to be dependent upon money lenders to a considerable extent for its credit needs. Very small industries, mostly in the unorganised sector, have virtually no institutional source for funds.
- Also, there has been criticism that the new monetary policy framework has reduced RBI’s role to just inflation manager with little help from government fiscal policy.
- Transmission of changes in policy rates is not fairly transferred by commercial banks to consumers. For example, In terms of the marginal cost lending rate (MCLR) by the banks (as per the data released by the RBI), the rate reduction was only 10 bps against the reduction of 250 bps by the RBI.
Conclusion
- Thus, monetary policy holds an important role in a country’s growth and development.
- Till now, the monetary policy has fared well but there is a need to enhance the transmission of changes made to it by RBI to get better outcomes and impacts on the economy.
