From UPSC perspective, the following things are important :
Prelims level : MPC
Mains level : Paper 3- Tackling inflation while maintaining the availability of easy money
The MPC decided on Friday to leave the Repo rate unchanged at 4%. However, the RBI faces a dilemma over the excess liquidity in the economy while tackling inflation.
Limits of monetary policy
- Even though our economy slumped into a recession in the first half of 2020-21, there seems little further RBI can do with monetary policy to spur growth.
- Its monetary decision to leave its main policy rate unchanged at 4%, the rate at which it lends money to banks, thus seems appropriate.
- This is because retail inflation has hovered above its 6% upper tolerance limit for much of this year.
- It is the first time its 2016-adopted price-stability framework looks poised for failure.
- Meanwhile, it has announced wider coverage of an earlier scheme by which banks buy bonds issued by firms in specific stressed sectors–a way to ease credit.
Poor credit demand
- Supply-side measures have their limits of efficacy, with aggregate demand observed to be in a bad way and investments restrained by uncertainty.
- Therefore, RBI’s focus had to shift to the inflationary effects of excess liquidity detected in the economy.
- Oddly, this doesn’t seem to have happened.
- With over ₹6 trillion still being parked daily by banks with RBI at its reverse repo window, a reflection of poor credit demand.
Dilemma RBI faces in maintaining low interest rate
- Plus, India has seen a large sum of dollars coming into India.
- To keep the rupee’s global value stable and Indian exports competitive, RBI has been buying those dollars, thus raising our foreign exchange reserves and pumping more liquidity into the domestic arena.
- Sterilizing the inflationary effect of this usually requires bonds to be sold, which increases their market supply and pressures yields up-a dilution of its stance on easy money.
- This poses a dilemma that RBI may soon have to grapple with.
- RBI’s core task as a central bank, of watching both the external and internal stability of the currency under its charge, may get more complex than ever if capital inflows stay high, global investors see an opportunity in ‘carry trade’ profits, and price trends don’t go by its expectations.
If India’s broad policy frame is being pushed by our covid crisis towards a major reset, with the Centre’s fisc granted a freer run and its debt burden to be partially inflated away over the years, then that would call for another debate.