Monetary Policy Committee Notifications

Monetary Policy Committee Notifications

Communication gap between the MPC and RBI

Note4Students

From UPSC perspective, the following things are important :

Prelims level : GSAP

Mains level : Paper 3- Communication gap between MPC and RBI

Context

Communication is a critical element of monetary policy. Yet there seems to be a gap between what the MPC says and what the RBI does.

About MPC

  • The Reserve Bank of India Act, 1934 (RBI Act) has been amended by the Finance Act, 2016,  to provide for a statutory and institutionalised framework for a Monetary Policy Committee, for maintaining price stability, while keeping in mind the objective of growth.
  • Highest monetary policy-making body: By law, the Monetary Policy Committee is the highest monetary policy-making body in the land, tasked with deciding monetary policy changes at regular intervals.
  • Composition: The MPC will have six members – the RBI Governor (Chairperson), the RBI Deputy Governor in charge of monetary policy, one official nominated by the RBI Board and the remaining three members would represent the Government of India.
  • The MPC will be chaired by the Governor.
  • Under the inflation targeting regime, the most important role in communication belongs to the MPC.

Communication with public

  • Monetary policy changes are communicated through formal statements, with the discussions underlying these decisions also being published, so that the public can understand why the MPC decided the way that they did.
  • Communication gap: Over the past few years, a communication gap seems to have opened up between what the MPC has been saying and what the RBI has been doing, thereby potentially eroding the credibility of the IT framework.
  • Influencing inflation expectations: Communication is an important part of the ability of the central bank to influence inflation expectations. 

Following are the ways which indicate the communication gap between the RBI and the MPC, with several implications for the credibility of the MPC.

1] Separate statements

  • During the first few years of the inflation-targeting regime from 2016 to 2018, the process of communication worked quite well.
  • On the days of policy announcements, the governor and his deputies would participate in a press conference.
  • From 2019 onwards, however, things began to change.
  • Governor’s separate statement: The RBI began to release a separate governor’s statement on the day of the monetary policy meeting, presenting an inflation outlook and even explaining the decision taken by the MPC.
  • MPC statement: It has overlapped with the MPC statement; at times, it has seemed somewhat different.
  • For example, following the June 8 Monetary Policy Review the MPC highlighted inflation concerns, and voted in favour of raising the policy repo rate.
  • On the same day, a governor’s statement mentioned that the central bank will also remain focussed on the orderly completion of the government’s borrowing programme.
  • Confusion: The issuance of two such different statements can lead to confusion, especially as lowering inflation and lowering government bond yields are contradictory policy objectives.

Why is communication so crucial? To influence inflation expectations!

  • If the public believes the central bank is committed to keeping inflation under control, then it will act accordingly.
  • Firms will moderate their price increases, fearing that large price rises will make them uncompetitive.
  • Meanwhile, workers will accept moderate wage increases, while investors will accept low interest rates on their bond purchases.
  • With everyone acting in this way, it will be easier for the central bank to ensure that inflation indeed remains low.
  • Anchored inflation expectations: If inflation expectations are well anchored, then it becomes relatively easy for the central bank to ensure that inflation returns to the target level before too long.

2] Change in the Monetary Policy Corridor width during pandemic

  • Deciding the repo rate: The most important task of the MPC, enshrined in the RBI Act (Amended), 2016 that introduced IT, is to decide the repo rate, since this has long been the lynchpin of India’s monetary policy framework.
  •  Ever since the early 2000s, policy had aimed to keep overnight money market rates in a corridor, with the lower bound established by the reverse repo rate and the upper bound by the repo rate.
  • Since the width of this corridor was fixed, once the repo rate was decided, the reverse repo rate was automatically determined, and market overnight rates adjusted accordingly.
  • During the Covid-19 pandemic, the RBI constantly adjusted the reverse repo rate even as the MPC kept the repo rate unchanged.
  • As a result, the fixed width of the corridor was lost, and the MPC lost any role in determining interest rates.

3] Introduction of policy instruments outside the remit of MPC

  • During pandemic, the RBI introduced a number of new policy instruments, again outside the remit of the MPC.
  • GSAP: It brought in the GSAP programme through which it pre-commited to buying a certain amount of dated government bonds in order to control their yields.
  • Variable reverse repo auctions: It then introduced variable reverse repo auctions, and more recently, replaced the reverse repo rate with the long-dormant standing deposit facility rate.
  • The rationale for this was not explained in the MPC statement.
  • All unconventional monetary policy announcements were kept outside the MPC statement.
  • This raised the questions about the role of the committee in deciding monetary policy actions at a crucial time like the pandemic.

4] Intervention in the foreign exchange market

  • The RBI has been intervening in the foreign exchange market to manage the rupee.
  • Forex interventions by definition influence the domestic monetary base and inflation.
  • Yet the MPC in its monetary policy statements does not discuss either the exchange rate dynamics or the forex interventions.
  • Just as it does not discuss the RBI’s interventions in the bond market to lower the yields.

Way forward

  • In its latest two statements, the MPC indicated that policy would now be focusing on bringing India’s inflation rate under control.
  • Clear policy framework: If the RBI is going to be successful in this endeavour, the first step must be to close the communication gap, by reintroducing a simple and clear policy framework and restoring the central role of the MPC.

Conclusion

The net result of all these actions is a potential loss of both clarity and credibility. The communication gap will need to be closed in order for the RBI to become successful in bringing inflation back to its 4 per cent target level.

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Back2Basics: Monetary Policy Corridor

  • The Corridor in the monetary policy of the RBI refers to the area between the reverse repo rate and the MSF rate.
  • Reverse repo rate will be the lowest of the policy rates whereas Marginal Standing Facility is something like an upper ceiling with a higher rate than the repo rate.
  • The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.
  • As per the monetary policy of the RBI, ideally, the call rate should travel within the corridor showing a comfortable liquidity situation in the financial system and economy.

What is GSAP?

  • The G-Sec Acquisition Programme (G-SAP) is basically an unconditional and a structured Open Market Operation (OMO), of a much larger scale and size.
  • G-SAP is an OMO with a ‘distinct character’.
  • The word ‘unconditional’ here connotes that RBI has committed upfront that it will buy G-Secs irrespective of the market sentiment.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Explained: Repo Rate in India

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Repo Rate

Mains level : Inflation targetting by MPC

Earlier this month, the RBI, in a surprise move decided unanimously to raise the “policy repo rate by 40 basis points to 4.40%, with immediate effect”.

What is the Repo Rate?

  • The repo rate is one of several direct and indirect instruments that are used by the RBI for implementing monetary policy.
  • Specifically, the RBI defines the repo rate as the fixed interest rate at which it provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
  • In other words, when banks have short-term requirements for funds, they can place government securities that they hold with the central bank and borrow money against these securities at the repo rate.
  • Since this is the rate of interest that the RBI charges commercial banks such as SBI and ICICI Bank when it lends them money, it serves as a key benchmark for the lenders to in turn price the loans they offer to their borrowers.

Why is the repo rate such a crucial monetary tool?

  • According to Investopedia, when government central banks repurchase securities from commercial lenders, they do so at a discounted rate that is known as the repo rate.
  • The repo rate system allows central banks to control the money supply within economies by increasing or decreasing the availability of funds.

How does the repo rate work?

  • Besides the direct loan pricing relationship, the repo rate also functions as a monetary tool by helping to regulate the availability of liquidity or funds in the banking system.
  • For instance, when the repo rate is decreased, banks may find an incentive to sell securities back to the government in return for cash.
  • This increases the money supply available to the general economy.
  • Conversely, when the repo rate is increased, lenders would end up thinking twice before borrowing from the central bank at the repo window thus, reducing the availability of money supply in the economy.
  • Since inflation is caused by more money chasing the same quantity of goods and services available in an economy, central banks tend to target regulation of money supply as a means to slow inflation.

What impact can a repo rate change have on inflation?

  • Inflation can broadly be: mainly demand driven price gains, or a result of supply side factors.
  • This in turn push up the costs of inputs used by producers of goods and providers of services.
  • It is thus spurring inflation, or most often caused by a combination of both demand and supply side pressures.
  • Changes to the repo rate to influence interest rates and the availability of money supply primarily work only on the demand side.
  • It makes credit more expensive and savings more attractive and therefore dissuading consumption.
  • However, they do little to address the supply side factors, be it the high price of commodities such as crude oil or metals or imported food items such as edible oils.

 

Try this PYQ:

Q.If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do?

  1. Cut and optimize the Statutory Liquidity Ratio
  2. Increase the Marginal Standing Facility Rate
  3. Cut the Bank Rate and Repo Rate

Select the correct answer using the code given below:

(a) 1 and 2 only

(b) 2 only

(c) 1 and 3 only

(d) 1, 2 and 3

 

Post your answers here.
3
Please leave a feedback on thisx

 

 

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By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Control inflation by acting on liquidity

Note4Students

From UPSC perspective, the following things are important :

Prelims level : CRR

Mains level : Paper 3- Dealing with inflation challenge through liquidity measures

Context

The recent action of the Reserve Bank of India (RBI) to raise the repo rate by 40 basis points and cash reserve ratio (CRR) by 50 basis points is a recognition of the serious situation with respect to inflation in our country and the resolve to tackle inflation.

Inflation in India and role of government expenditure

  • India’s CPI inflation has been fluctuating around a high level.
  • As early as October 2020, it had hit a peak of 7.61%.
  • It had remained at a high level of over 6% since April 2020.
  • It did come down after December 2020 but has started rising significantly from January 2022.
  • On the other hand, the Wholesale Price Index (WPI) inflation had remained in double digits since April 2021. The GDP implicit price deflator-based inflation rate for 2021-22 is 9.6%.
  • Even though the RBI’s mandate is with respect to CPI inflation, policymakers cannot ignore the behaviour of other price indices.
  • After the advent of COVID-19, the major concern of policymakers all over the world was to revive demand.
  • Keynesian prescription: This was sought to be achieved by raising government expenditure.
  • Thus, the expansion in government expenditure did not immediately result in increased production in countries where the lockdown was taken seriously.
  • However, the Keynesian multiplier does not work when there are supply constraints as in developing countries.
  • That is why the multiplier operates in nominal terms rather than in real terms in such countries.
  • Something similar has happened in the present case where the supply constraint came from a non-mobility of factors of production.
  • Nevertheless, the prescription of enhanced government expenditure is still valid under the present circumstances.
  • Perhaps the increase in output could happen with a lag and also with the relaxation of restrictions.

Role of monetary policy

  • Why lover money multiplier rate? Initially, the focus of monetary policy in India has been to keep the interest rate low and increase the availability of liquidity through various channels, some of which have been newly introduced.
  • However, the growth rate of money was below the growth rate in reserve money.
  • This is because of lower credit growth which also depends on business sentiment and investment climate.
  • Thus the money multiplier is lower than usual.
  • The Government’s borrowing programme which was larger went through smoothly, thanks to abundant liquidity.
  • Even as the economy picked up steam in 2021-22, inflation also became an issue, this is a worldwide phenomenon.
  • In India too there is a shift in monetary policy.

Analysing the cause of inflation

  • While discussing inflation, analysts focus almost exclusively on the increases in the prices of individual commodities such as crude oil as the primary cause of inflation.
  • General price level: Supply disruptions due to domestic or external factors may explain the behaviour of individual prices but not the general price level which is what inflation is about.
  • Given a budget constraint, there will only be an adjustment of relative prices.
  • Besides the fact that any cost-push increase in one commodity may get generalised, it is the adjustment that happens at the macro level which becomes critical.
  • It is the adjustment in the macro level of liquidity that sustains inflation.

Inflation and growth

  • The possible trade-off between inflation and growth has a long history in economic literature.
  • The Phillip’s curve has been analysed theoretically and empirically.
  • Tobin called the Phillip’s curve a ‘cruel dilemma’ because it suggested that full employment was not compatible with price stability. 
  • The critical question flowing from these discussions on trade-off is whether cost-push factors can by themselves generate inflation.
  • In the current situation, it is sometimes argued that inflation will come down, if some part of the increase in crude prices is absorbed by the government. 
  • If the additional burden borne by the government (through loss of revenue) is not offset by expenditures, the overall deficit will widen.
  • The borrowing programme will increase and additional liquidity support may be required.

Concomitant decisions on CRR and repo rate

  • These are concomitant decisions. Central banks cannot order interest rates.
  • For a rise in the interest rate to stick, appropriate actions must be taken to contract liquidity.
  • That is what the rise in CRR will do.
  • In the absence of a rise in CRR, liquidity will have to be sucked by open market operations.

Conclusion

Beyond a point, inflation itself can hinder growth. Negative real rates of interest on savings are not conducive to growth. If we want to control inflation, action on liquidity is very much needed with a concomitant rise in the interest rate on deposits and loans.

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By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Inflation control needs another model

Note4Students

From UPSC perspective, the following things are important :

Prelims level : CPI and WPI

Mains level : Paper 3- Need for the review of inflation targeting model

Context

At the conclusion of the April meeting, the Monetary Policy Committee had already warned that the focus will henceforth be on inflation. Yesterday it raised the repo rate somewhat sooner than was expected by the market.

 Discourse on inflation engaged in by the western central banks

  • Inflation reflects an excess of output over its ‘natural’ level.
  • Inflation targeting refers to the policy of controlling inflation by raising the interest rate over which the central bank has control, i.e. the rate at which it lends to commercial banks, the ‘repo rate’.
  • This, it is argued, will induce firms to stay their investment plans and reduce inventories, lowering production.
  • As economy-wide output declines, becoming equal to the natural level of output, inflation will cease.
  • This story does not just legitimise a policy of output contraction for inflation but sees it as optimal.
  • The natural level of output itself is the productive counterpart of the natural level of employment, the level that obtains in a freely functioning labour market.
  • So, at the natural level of output, the economy is deemed to be at full employment.
  • Salient in the context is the fact that the natural level of output is unobservable.
  • Hence inflation as a reflection of an “overheating” economy is something that must be taken on trust.

Inflation control in India

  • Not surprisingly for a theory based on an unobservable variable, the proposition that inflation is due to an overheating economy fares poorly when put to a statistical test for India. 
  • There is not a single demonstration of the empirical validity of the model of inflation presented in the RBI report of 2014, which recommended a move to inflation targeting.
  • On the other hand inflation in India can be explained in terms of the movement of the prices of agricultural goods and, to a lesser extent, imported oil.
  • How effective is monetary policy in controlling inflation: The implication of this finding is damaging for the claim that monetary policy can control inflation, for neither the price of agricultural goods nor that of imported oil is under the central bank’s control.
  • The only route by which monetary policy can, in principle, control inflation is by curbing the growth of non-agricultural output, which would in turn lower the growth of demand for agricultural goods.
  • As the demand for agricultural goods slows, so will inflation, but this comes at the cost of output and employment.
  • At least, this is the theory.
  • Whether this takes place in practice depends upon the extent to which changes in the repo rate are transmitted to commercial bank lending rates.

Way forward

  • Focus on supply of agricultural goods: The implication for the policymaker that inflation is driven by agricultural goods prices, as is the case in India presently, is that the focus should be on increasing the supply of these goods.
  • Growing per capita income in India has shifted the average consumption basket towards foods rich in minerals, such as fruits and vegetables, and protein, such as milk and meat.
  • But the expansion of the supply of these foods has been lower than the growth in demand for them.
  • So a concerted drive to increase the supply of food other than rice and wheat holds the key.
  • Costly food threatens the health of the population, as people economise on their food intake, and holds back the economy, as only a small part of a household’s budget can be spent on non-agricultural goods.

Conclusion

Monetary policy manoeuvres, typified by the RBI’s raising of the repo rate is not an efficient solution for agricultural price-driven inflation. Any lasting inflation control would require placing agricultural production on a steady footing, with continuously rising productivity.

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By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

RBI surprises with 40 bps rate increase in Repo Rate

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Repo Rate

Mains level : Inflation targetting by MPC

The Reserve Bank of India (RBI), in a sudden move, raised the repo rate by 40 basis points (bps) to 4.4% citing inflation that was globally rising alarmingly and spreading fast.

Why in news?

  • The repo rate increase was the first since August 2018.
  • The MPC retained its ‘accommodative’ policy stance even as it focuses on withdrawal of accommodation to keep inflation within the target range while supporting growth.
  • Due to Ukraine War, persistent and spreading inflationary pressures are becoming more acute with every passing day.

Hues over the REPO spike

  • The move — to have such a meeting and to raise the interest rates — is, at two different levels, both surprising and obvious.
  • It is surprising because the RBI’s MPC meets once every two months — and the meeting this week was not scheduled.

What is Repo Rate?

  • Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds.
  • It is used by monetary authorities to control inflation.
  • In the event of inflation, central banks increase repo rate as this acts as a disincentive for banks to borrow from the central bank.
  • This ultimately reduces the money supply in the economy and thus helps in arresting inflation.

How does the repo dynamics work?

  • When there is a shortage of funds, commercial banks borrow money from the central bank which is repaid according to the repo rate applicable.
  • The central bank provides these short terms loans against securities such as treasury bills or government bonds.
  • This monetary policy is used by the central bank to control inflation or increase the liquidity of banks.
  • The government increases the repo rate when they need to control prices and restrict borrowings.
  • An increase in repo rate means commercial banks have to pay more interest for the money lent to them and therefore, a change in repo rate eventually affects public borrowings such as home loan, EMIs, etc.
  • From interest charged by commercial banks on loans to the returns from deposits, various financial and investment instruments are indirectly dependent on the repo rate.

What is accommodative stance of policy?

  • Accommodative monetary policy is when central banks expand the money supply to boost the economy. Monetary policies that are considered accommodative include lowering the Federal funds rate.
  • These measures are meant to make money less expensive to borrow and encourage more spending.

What triggered the RBI to take sudden decision?

  • Inflation has been rising for over two years: By law, the RBI is supposed to target retail inflation at 4%. Inflation constantly above 4% since last year.
  • Inflation has not been “transitory”: The reasons for high inflation have tended to change over the months due to wide range of reasons like war, crude oil prices rise, taxes on fuels etc.
  • Spike in crude oil prices is not new: The RBI has pointed to high crude oil prices in the wake of the Ukraine war, as one of the key reasons for high inflation in India.
  • High core inflation: The core inflation which is essentially the inflation rate stripped of the effect of fuel and food prices has been rising up. This is more worrisome for RBI since it cannot be altered overnight.
  • Monetary policy has lags. RBI waited too long: If the RBI wanted to contain inflation in May, it should have acted in February or at least in April. Raising rates right now may not bring down the inflation rate immediately.

Try this PYQ from CSP 2020:

Q.If the RBI decides to adopt an expansionist monetary policy, which of the following it would NOT do?

  1. Cut and optimize the statutory liquidity ratio
  2. Increase the Marginal Standing Facility Rate
  3. Cut the Bank Rate and Repo Rate

Select the correct answer using the code given below:

(a) 1 and 2 only

(b) 2 only

(c) 1 and 3 only

(d) 1, 2 and 3

 

Post your answers here:

2
Please leave a feedback on thisx

 


 

Back2Basics: Monetary Policy Committee (MPC)

  • The Monetary Policy Committee (MPC) is a committee of the RBI, which is entrusted with the task of fixing the benchmark policy interest rate (repo rate) to contain inflation within the specified target level.
  • The RBI Act, 1934 was amended by Finance Act (India), 2016 to constitute MPC to bring more transparency and accountability in fixing India’s Monetary Policy.
  • The policy is published after every meeting with each member explaining his opinions.
  • The committee is answerable to the Government of India if the inflation exceeds the range prescribed for three consecutive months.
  • Suggestions for setting up a MPC is not new and goes back to 2002 when YV Reddy committee proposed to establish an MPC, then Tarapore committee in 2006, Percy Mistry committee in 2007, Raghuram Rajan committee in 2009 and then Urjit Patel Committee in 2013.

Composition and Working

  • The committee comprises six members – three officials of the RBI and three external members nominated by the Government of India.
  • The meetings of the Monetary Policy Committee are held at least 4 times a year and it publishes its decisions after each such meeting.
  • The Governor of RBI is the chairperson ex officio of the committee.
  • Decisions are taken by a majority with the Governor having the casting vote in case of a tie.
  • They need to observe a “silent period” seven days before and after the rate decision for “utmost confidentiality”.

 

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By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Challenges in RBI’s inflation management

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Liquidity Adjustment Framework

Mains level : Paper 3- Standing Deposit Facility

Context

The first bi-monthly meeting of the Reserve Bank of India’s Monetary Policy Committee (MPC) for the current financial year reaffirmed its focus on inflation management.

Towards the normalisation of monetary policy

  • The MPC voted to keep the policy rate unchanged at 4 per cent and retained its accommodative stance.
  • However, the wording was changed to “remain accommodative while focusing on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth.”
  • This statement sets the stage for a shift to a neutral stance in the next meeting and policy rate hikes in subsequent meetings.
  • RBI has announced the withdrawal of some of the steps taken during the pandemic to support the economy.
  • These will foster the normalisation of monetary policy.

Inflation challenge

  • The central bank has acknowledged that the disruptions caused by the Russia-Ukraine crisis have upended their growth and inflation outlook.
  • It has steeply revised its inflation projection from 4.5 per cent earlier to 5.7 per cent now for the current financial year.
  • The projection is based on an average global crude oil price of $100 per barrel.
  • The Food and Agriculture Organisation’s (FAO’s) Food Price Index, a gauge of global food prices, posted a record growth of 12.6 per cent from February.

Formalisation of Liquidity Adjustment Framework (LAF)

  • The RBI has been managing liquidity infused into the system during the pandemic through the Variable Rate Reverse Repo Auctions (VRRR) to withdraw liquidity and Variable Rate Repo auctions to inject liquidity.
  • RBI has now formalised the Liquidity Adjustment Framework (LAF).
  • The LAF is a framework to absorb and inject liquidity into the banking system.
  • The LAF is now a symmetric corridor with a width of 50 basis points.
  • The policy repo rate is at the centre of the corridor, with the MSF 25 basis points above the policy rate and the SDF 25 basis points below the policy rate.

What is a Standing Deposit Facility

  • The RBI has introduced the Standing Deposit Facility (SDF) as the lower bound of the LAF corridor to absorb liquidity.
  • The idea of the SDF was first mooted by the Urjit Patel Committee report on the monetary policy framework.
  • The RBI Act was amended through the Finance Act of 2018 to allow RBI to use this instrument.
  • The SDF will be a facility available to banks to park their funds.
  • The SDF will serve as the standing liquidity absorption facility at the lower end of the LAF corridor.
  • At the upper end of the corridor is the Marginal Standing Facility (MSF) to inject liquidity.
  • Through the SDF, the RBI can absorb liquidity without placing government securities as collateral, hence it will give greater flexibility to the central bank.
  • The change also marks a shift away from reverse repo being the effective policy rate.

Key takeaways

  • While on the face of it, there are no rate hikes, the shift from the reverse repo rate to the SDF signals a tightening of monetary policy.
  • There is a 40 basis points increase in the floor rate.
  •  In the medium run, the call money rate would move towards the new LAF corridor, thus bringing orderly conditions in the money market.
  • As RBI begins to normalise liquidity in a calibrated manner, its ability to manage bond yields will likely be limited.
  • Yields on bonds are likely to inch up and remain above the 7 per cent mark.
  • Going forward, the trade-off between managing inflation and the borrowing programme of the government will become challenging.

Conclusion

For now the RBI has rightly decided to place top priority on inflation management. This will help in maintaining the credibility of the inflation targeting framework.

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By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

RBI shift on monetary policy

Note4Students

From UPSC perspective, the following things are important :

Prelims level : LAF corridor

Mains level : Paper 3- Monetary policy normalisation

Context

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) on Friday gave a surprise, with a formal start to policy normalisation. This was contrary to the predominant market expectations of a hold.

RBI on the path of policy normalisation

  • Focus on target of 4% +/- 2%: While the MPC voted unanimously to remain accommodative, in a change of language, the focus would now be on “withdrawal of accommodation to ensure that (CPI) inflation remains within the target (of 4 per cent +/- 2 per cent) going forward”.
  •  Remember, the RBI had become a (flexible) inflation-targeting central bank since FY17, whose primary objective is price stability, that is, inflation management.
  • The Liquidity Adjustment Facility (LAF) corridor was narrowed back to the conventional 0.25 percentage points from the earlier extraordinary pandemic widening in late March 2020.
  • The cap of the erstwhile corridor was the repo rate and the floor was the reverse repo.
  • Now, while the repo rate was held at 4.0 per cent and the latter at 3.35 per cent, the floor of the corridor was increased by 0.4 percentage points from 3.35 per cent.
  • There was also a change in the monetary policy orientation, of which the stance is one component.
  • The priority for monetary policy now is inflation, growth and financial stability, in that order.

Reasons for unexpected tightening of policy

  • Inflation concerns: Despite uncertainty over growth impulses and demand concentrated at the upper-income level households, inflation has increasingly emerged as a big concern.
  •  Given that inflation is likely to average 6.1 per cent in Q4 of FY22, this increases the risk of inflation remaining above the 6 per cent upper target for three consecutive quarters, necessitating an explanation to the government by the MPC.
  • One comforting aspect of this scenario is that household inflation expectations remain anchored, with the median of three months to one year ahead expectations (as of March ’22) rising by only 0.1 percentage points from the earlier January readings.
  • Stabilisation of demand: On demand conditions, the RBI scaled-down the FY23 real GDP growth projection to 7.2 per cent (from 7.8 per cent), indicating that a combination of continuing supply dislocations, slowing global economy and trade, high prices and financial markets volatility are likely to take a toll.
  • One possible reconciliation with modest GDP growth is continuing weakness in services, which is also borne out by channel checks.
  • Certainly, continuing high inflation is likely to lead to some demand destruction, which will act as an automatic stabiliser.
  • A relatively loose fiscal policy is likely to offset some of this reduced demand, particularly with continuing subsidies to lower-income households.
  • Financial stability: This has multiple dimensions – interest and foreign exchange rates, market volatility, banking sector asset stress, and so on.
  • An important objective for the RBI is the management of money supply and system liquidity.
  • In a rising rate cycle, with a large borrowing programme of the Centre and state governments, interest rates on sovereign bonds are likely to increase without a measure of support from the RBI through Open Market Operations (OMOs).
  • This will entail injecting more liquidity into an already large surplus, which might add to inflationary pressures.
  • The introduction of the overnight Standing Deposit Facility (SDF) was a significant measure in this context.
  • Unlike the reverse repo facility, the RBI will not need to give banks government bonds as collateral against the funds they deposit.
  • This is thus a more flexible instrument should a shortage of government bonds in RBI holdings actually transpire under some eventuality, say the need to absorb large capital inflows post a bond index inclusion.

What are the implications?

  • Interest rates will begin to increase but, for bank borrowers, this is likely to be a very gradual process.
  • For corporates and other wholesale borrowers, who also borrow from bond markets, this increase is likely to be faster as the surplus system liquidity is gradually drained.
  • How this is likely to affect demand for credit is uncertain, given the capex push of the government, some revival of private sector investment and likely continuing demand for housing.

Conclusion

This cycle of policy tightening will present a particularly difficult mix of economic and financial trade-offs, but RBI has demonstrated the ability to innovatively use the multiple instruments at its disposal to ensure an orderly transition.

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Back2Basics: Liquidity Adjustment Facility corridor

  • Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements or repos.
  • LAF is used to aid banks in adjusting the day to day mismatches in liquidity (frictional liquidity deficit/surplus).
  • The liquidity adjustment facility corridor is the excess of repo rate over reverse repo.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

What is Reverse Repo Normalization?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Repo , Reverse Repo, Normalization

Mains level : Normalization of Monetary Policy

In a recent report, the State Bank of India, which is the largest public sector bank in the country, has stated that the stage is set for a reverse repo normalization.

What is Monetary Policy Normalisation?

The RBI keeps tweaking the total amount of money in the economy to ensure smooth functioning by two types of policies:

(I) Loose Monetary Policy

When the RBI wants to boost economic activity it adopts a so-called “loose monetary policy”.

There are two parts to such a policy:

  1. RBI injects more money (liquidity) into the economy: It does so by buying government bonds from the market. As the RBI buys these bonds, it pays back money to the bondholders, thus injecting more money into the economy.
  2. RBI also lowers the interest rate: it charges banks when it lends money to them; this rate is called the repo rate. Lower interest rates and more liquidity, together, are expected to boost both consumption and production in the economy.

(II) Tight Monetary Policy

  • It involves the RBI raising interest rates and sucking liquidity out of the economy by selling bonds (and taking money out of the system).
  • When any central bank finds that a loose monetary policy has started becoming counterproductive in reducing inflation, the central bank “normalizes the policy” by tightening the monetary policy stance.

What is Reverse Repo?

  • An interest rate that the RBI pays to the commercial banks when they park their excess “liquidity” (money) with the RBI.
  • The reverse repo, thus, is the exact opposite of the repo rate.
  • Under normal a circumstance, that is when the economy is growing at a healthy pace, the repo rate becomes the benchmark interest rate in the economy.
  • That’s because it is the lowest rate of interest at which funds can be borrowed.
  • As such, the repo rate forms the floor interest rate for all other interest rates in the economy — be it the rate you pay for a car loan or a home loan or the interest you earn on your fixed deposit, etc.

How does Reverse Repo fit into policy normalization?

  • Imagine a scenario where the RBI pumps more and more liquidity into the market but there are no takers of fresh loans.
  • This is because the banks are unwilling to lend or because there is no genuine demand for new loans in the economy.
  • In such a scenario, the action shifts from repo rate to reverse repo rate because banks are no longer interested in borrowing money from the RBI.
  • Rather they are more interested in parking their excess liquidity with the RBI. And that is how the reverse repo becomes the actual benchmark interest rate in the economy.

What does reverse repo normalization mean?

  • Simply put, it means the reverse repo rates will go up.
  • Over the past few months, in the face of rising inflation, several central banks across the world have either increased interest rates or signaled that they would do so soon.
  • In India, too, it is expected that the RBI will raise the repo rate.
  • But before that, it is expected that the RBI will raise the reverse repo rate and reduce the gap between the two rates.
  • In the immediate aftermath of Covid, RBI had increased this gap.

Implications of such policy

  • Incentivize commercial banks to park excess funds with RBI, thus sucking some liquidity out of the system.
  • The next step would be raising the repo rate.
  • This process of normalization, which is aimed at curbing inflation, will not only reduce excess liquidity but also result in higher interest rates across the board in the Indian economy.
  • This will help reduce the demand for money among consumers (since it would make more sense to just keep the money in the bank) and make it costlier for businesses to borrow fresh loans.

Try this PYQ from CSP 2020:

Q.If the RBI decides to adopt an expansionist monetary policy, which of the following it would NOT do?

  1. Cut and optimize the statutory liquidity ratio
  2. Increase the Marginal Standing Facility Rate
  3. Cut the Bank Rate and Repo Rate

Select the correct answer using the code given below:

(a) 1 and 2 only

(b) 2 only

(c) 1 and 3 only

(d) 1, 2 and 3

 

Post your answers here:
4
Please leave a feedback on thisx

 

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By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

What is the Regression Theorem?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Regression Theorem

Mains level : Not Much

This newscard is an excerpt from the original article published in the TH e-paper edition.

Regression Theorem

  • The regression theorem refers to a theory of the origin of money.
  • It states that money must have originated as a commodity with intrinsic value in the marketplace.
  • The idea was first proposed by Austrian economist Carl Menger in his 1892 work “On the Origins of Money.”
  • This theory is offered as an alternative to the state theory of money which states that money (fiat money) can come into existence only when it is backed by the government.

Evolution of Money

  • The regression theory argues that money comes into existence through a gradual process of evolution in the marketplace, without the need for any government sanction.
  • Economists who try to explain the regression theory generally start with the question of why money, particularly fiat money which is simply just a piece of paper, has any value at all in the marketplace.
  • The most common answer to this question is that fiat money can be used to buy other useful goods such as houses, cars etc.
  • But this answer is insufficient —it tries to tackle the question of why fiat money can buy other useful goods by simply saying that it can buy other useful goods.

Why is fiat money, which has little intrinsic value, considered valuable?

  • In real life, people accept money in exchange for goods in the present because they are aware that money was accepted as a medium in exchange for other goods in the past.
  • For example, people accept wages in the US dollar today because they are aware that the dollar was used to buy cars, groceries and other goods in the market yesterday.
  • This gives them confidence in the value of their money.

What made people accept money in exchange for other useful goods in the past?

Ans. Intrinsic Value

  • Economists who advocate the regression theory of money argue that money must have originated as a useful commodity like gold or silver or the barter system.
  • This is the only way, they argue, it could have possibly been accepted by people in exchange for other useful goods at some point in the past.
  • If a thing did not possess any intrinsic value, it is unlikely that people in the marketplace would have accepted it in exchange for other goods and services.
  • So, commodities like gold and silver must have been traded in exchange for other goods and services at some point in history purely because they offered some kind of personal utility to people.
  • For example, these precious metals could have been used to make ornaments, to fill teeth, etc., which gives them intrinsic value.
  • They maintain value over time because their supply cannot be easily ramped up as mining gold involves significant production costs.

 

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By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Why policymakers prefer targeting of Retail Inflation over Wholesale Inflation?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Wholesale and Retail (Consumer) Inflation

Mains level : Inflation control in India

The wholesale inflation in India has grown by double digits. This is the highest year-on-year increase recorded in any month since the start of the 2011-12 data series.

Context

  • It is surprising policymakers are not looking as concerned as the inflation figures show.
  • The Finance Ministry has largely focused on the trend in retail inflation — or the inflation rate at the level of retail consumers.
  • It is not just the policymakers within the government who prefer to focus on retail inflation but also the RBI.

Wholesale and Retail (Consumer) Inflation

  • The wholesale and retail (consumer) inflation rates are based on the wholesale price index (WPI) and the consumer price index (CPI), respectively.
  • In other words, we make two separate indices — one each for wholesale prices and retail prices — and see how the index values have gone up in a particular month as against the same month last year.
  • The percentage change is the rate of inflation.
  • The CPI-based inflation data is compiled by the Ministry of Statistics and Programme Implementation (or MoSPI) and the WPI-based inflation data is put together by DPIIT.

The tables alongside detail how the two indices — WPI and CPI — differ in their composition. There are two key differences.

[A] Wholesale Price Index

Component Weight (in %) Inflation rate (in %);

Nov 2021

All Commodities 100.00 14.23
Primary Articles 22.62 10.34
Fuel & Power 13.15 39.81
Manufactured Products 64.23 11.92

[B] Consumer Price Index

Component Weight (in %) Inflation rate (in %); 

Nov 2021

General Index 100.00 4.91
Food and beverages 45.86 2.60
Pan, tobacco and intoxicants 2.38 4.05
Clothing and footwear 6.53 7.94
Housing 10.07 3.66
Fuel and light 6.84 13.35
Miscellaneous (services) 28.32 6.75

A Comparison

(1) Manufactured Goods Vs. Food Items

  • WPI is dominated by the prices of manufactured goods while CPI is dominated by the prices of food articles.
  • As such, if the year-on-year increase in the prices of food articles is subdued, as is the case at present, chances are that the overall (also called headline) retail inflation will be within reasonable bounds.
  • In WPI, if manufactured products are getting costlier at the wholesale level then that would likely spike wholesale inflation regardless of how food prices are doing at the wholesale level.

(2) Accounting Service

  • Two, WPI does not take into account the change in prices of services. But CPI does.
  • If services such as transport, education, recreation and amusement, personal care etc. get significantly costlier, then retail inflation will rise but there will be no impact on wholesale price inflation.

Why do policymakers prefer targeting retail inflation instead of wholesale inflation rate?

  • RBI’s limitations: RBI is the monetary authority that has little ability to control food and fuel prices. Ex: raising the repo rate (rate at which RBI lends money to banks) is unlikely to contain the price of vegetables if any disruptions have led to a sudden spike.
  • Non-commodity Inflation: Wholesale inflation does not capture price movements in non-commodity-producing sectors like services, which constitute close to two-thirds of economic activity in India.
  • Large revisions in WPI: Movements in WPI often reflect large external shocks and as such, the wholesale inflation rate is often subject to large revisions.

Arguments in favour of CPI-based inflation targeting

  • Commodity basket: A crucial reason why CPI-based inflation could not be ignored is the fact that it has almost 57% dominance of food and fuel prices.
  • Affecting general public: Since most people use retail inflation as a way to arrive at their real earnings, and use it for wage negotiations etc., it makes more sense for policymakers,
  • Public faith: The choice of CPI establishes ‘trust’ viz., economic agents note that the monetary policy maker is targeting an index that is relevant for households and businesses.
  • Inflation affecting people: True inflation that consumers face is in the retail market. It is for this reason that almost all central banks in big economies use CPI as their primary price indicator.

Impact of Wholesale inflation on Retail

  • The Urjit Patel committee analysed the relationship between WPI and CPI based on monthly data from January 2000 to December 2013 — a total of 14 years.
  • When they looked at the impact of an increase in WPI-food inflation on CPI food inflation, they found it to be “significant”.
  • It stated that higher food inflation in wholesale markets leads to an increase in retail food inflation “till two months”.
  • An increase in retail food inflation leads to a corresponding increase in WPI-food inflation.

 

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By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

RBI must tackle surplus liquidity on way to policy normalisation

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Monetary policy corridor

Mains level : Paper 3- Monetary policy normalisation and challenges involved in it

Context

Monetary Policy Committee (MPC) voted to maintain status quo on policy rates, with one member continuing to dissent on the “accommodative” stance of policy.

What is accommodative stance of policy?

Accommodative monetary policy is when central banks expand the money supply to boost the economy. Monetary policies that are considered accommodative include lowering the Federal funds rate. These measures are meant to make money less expensive to borrow and encourage more spending.

Overview of RBI policy measures during Covid-related lockdown

  • Cut in policy rates and injection of liquidity: The RBI had moved proactively to cut the repo and reverse repo rate and inject unprecedented amounts of funds into banks and other intermediaries.
  • The short-term interest rate at reverse repo level: a combination of the lower reverse repo rate and the large liquidity injection had resulted in a drop in various short-term rates down to (and occasionally below) the reverse repo rate, making it the effective operating rate of monetary policy.
  • Gap between repo and reverse repo increased to 65 bps: In addition, both the repo and reverse repo rates had been cut to 4.0 and 3.35 per cent, respectively, with the gap – the “corridor” – between the rates widening from the usual 25 basis points to 65 bps.

Central bank’s role in modern monetary policy

  • Determining basic overnight interest rate: A central bank’s main role in modern monetary policy operating procedures is to determine the basic overnight interest rate, deemed to be consistent with prevailing macroeconomic conditions and their economic policy objectives, in balancing the ecosystem for sustained growth together with moderate inflation.
  • This is achieved through buying and selling very short-term (predominantly overnight) funds (mainly) from banks to keep a specified operating rate (the weighted average call rate in our case) very close to the policy rate.

Liquidity management: Key pillar of monetary policy normalisation

  • Liquidity management: Liquidity management in the extended banking and financial system (which includes non-banking intermediaries like NBFCs, mutual funds and others) will now be the key pillar of normalisation.
  • This process is the domain of RBI and not MPC.
  • These operations will be conducted within RBI’s liquidity management framework.
  •  There are two sources of liquidity additions:
  • (i) Exogenous: which are largely due to inflows of foreign currency funds and outflows of currency in circulation (cash) from the banking sector.
  • (ii) Voluntary or endogenous: which is the result of the creation of base money by RBI through buying and selling of bonds, thereby injecting or extracting rupee funds.

How RBI is managing liquidity surplus?

  • Stopped GSAP and OMOs: Post the October review, RBI had stopped buying bonds under the Govt Securities Asset Purchase (GSAP) and done negligible Open Market Operations (OMOs), thereby stopping addition of voluntary liquidity injection into the system, our own version of “tapering”.
  • Union government balances with RBI, arising from cash flow mismatches between receipts and expenditures, has hybrid characteristics and also impacts liquidity.
  • Use of reverse repo window: RBI has used the reverse repo window to absorb almost all this liquidity surplus from banks.
  • Allowed repaying TLRTOs: It has again allowed banks the option to prepay the outstanding borrowings from the Targeted Long Term Repo Operations (TLTROs), thereby potentially extracting another Rs 70,000 crores.

How RBI is managing interest rate in the policy normalisation process

  • Increased rates and closed the gap between repo and reverse repo: RBI – post the October review – has gradually guided short-term rates up with a sure hand from near the reverse repo rate to close to the repo rate.
  • It has shifted its liquidity absorption operations from the predominant use of fixed rate reverse repos (FRRR) into (largely) 14-day variable rate reverse repo (VRRR) auctions to guide a rise in interest rates.
  • Since early October, these rates had steadily moved up in a smooth and orderly fashion up to 3.75-3.9 per cent.
  • The VRRR rates moving up have also resulted in various short-term funding interest rates like 90-day Treasury Bills, Commercial Papers (CP) and banks’ Certificates of Deposits (CD) moving up from the reverse repo rate or below in September to 3.5 per cent and higher since December.
  • The OMO and GSAP operations have also helped in managing medium- and longer-term interest rates in the yield curve.

Way forward

  • There is a likelihood of further additions to exogenous system liquidity.
  • Other instruments to absorb surpluses: There might consequently be a need for other instruments to absorb these surpluses apart from VRRR auctions.
  • Liquidity surplus of non-banking intermediaries: Managing liquidity surpluses of the non-banking intermediaries, especially mutual funds, will be another challenge since they do not have direct access to VRRR operations.

Consider the question “Since the onset of the Covid-related lockdowns, RBI had moved proactively to cut the repo and reverse repo rate and inject unprecedented amounts of funds into banks and other intermediaries. In this context, what are the challenges in monetary policy normalisation as RBI plans to absorb the excess liquidity and increase the interest rates ?”

Conclusion

The shift to the tightening phase, with hikes in the repo rate, is likely towards the late months of FY23, with shifts “if warranted by changes in the economic outlook”.

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Back2Basics: Monetary Policy Corridor

  • The Corridor in monetary policy of the RBI refers to the area between the reverse repo rate and the MSF rate.
  • Reverse repo rate will be the lowest of the policy rates whereas Marginal Standing Facility is something like an upper ceiling with a higher rate than the repo rate.
  • The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

RBI’s monetary policy statement

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Taper tantrum

Mains level : Paper 3- MPC decision on interest rates

Context

The Monetary Policy Committee of the RBI kept the benchmark policy rates unchanged, and retained the accommodative stance in its October review.

Factors playing part in monetary policy decisions

  • It’s important to remember that monetary policy these days is influenced by both local macroeconomic developments and the global monetary policy direction, with the former playing a dominant role.
  • Locally, after the second wave of the pandemic, a variety of indicators such as the Purchasing Managers Index (manufacturing and services), mobility indicators, government tax collections, exports and imports are pointing at an improvement in economic activity.
  • Then there is the good news on the monsoon front. With a late pick-up in rains, the cumulative deficiency in this monsoon season has come down to just 1 per cent of the long-period average (LPA).
  • Since the MPC’s August 2021 policy review, Covid-19 cases have trended down and there has been admirable progress on the vaccination front.
  • Also, despite high year-on-year growth numbers, the level of economic activity this fiscal will only be 1.5 per cent above 2019-2020.

Trends emerging from the economic recovery

  • Role of government: Capital expenditure of both the Centre and states is on track to meet the budgetary commitment, supported by healthy tax collections.
  • Large companies on recovery path: Large companies in industrial sectors such as steel, cement, non-ferrous metals are operating at healthy utilisation levels, and have deleveraged their balance sheets.
  • Policy support for smaller companies: The going is not so good for the smaller ones.
  • Clearly, smaller companies need policy support. The extension of the Emergency Credit Line Guarantee Scheme is a recognition of that.
  • Private consumption is not broad-based either.
  • Even in goods consumption, which is faring better than services, the nature of demand seems skewed towards relatively higher-value items such as cars and utility vehicles.
  • This probably reflects the income dichotomy spawned by the pandemic.
  • Inflation: Its fall to 5.3 per cent in August offers only limited comfort for two reasons.
  • One, core and fuel inflation, which have 54 per cent weightage in CPI, remain stubbornly high.
  • Second, food prices have nudged down overall inflation.
  • Domestic growth-inflation dynamics suggest that the RBI has little option but to remain more tolerant of persistent price pressures, and hope that these will eventually prove transitory because they have been primarily driven by supply shocks caused by the pandemic.

Global monetary policy environment

  • Globally, the monetary policy environment is veering towards normalisation/tapering/interest-rate rise largely due to an upward surprise in inflation, or because some central banks feel the objectives of quantitative easing have been met.
  • Central banks in advanced economies such as Norway, Korea and New Zealand have recently raised rates.
  • The two systemically important central banks — the US Federal Reserve (Fed) and the European Central Bank (ECB) — view the current spike in inflation as fleeting and have communicated greater tolerance for it for a longer period.

Conclusion

The process of mopping up excess liquidity will slowly gain pace over the next few months, followed by a policy rate hike sometime around early 2022. By then, there should be enough clarity on the third wave and the stance of the Fed and the ECB.

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By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Crypto is not currency, must regulate it as asset: Former RBI DG

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Cryptocurrencies and Legal Tender Currency

Mains level : Issues with Cryptocurrencies

Former RBI Deputy Governor R. Gandhi made a case for treating and regulating crypto as a separate asset class with a view to enabling governments around the world to effectively deal with illegal activities associated with virtual currencies.

Why in news?

  • After quite a lot of debate over the years, people have fully understood that crypto cannot be a currency because the fundamental element of a currency that it should be a legal tender is missing in this case.
  • The general consensus among many policymakers is that it should be deemed as an asset, not as a currency, not as a payment instrument, and not as a financial instrument as there is no clear identified issuer.

What are Cryptocurrencies?

  • A cryptocurrency is a digital asset designed to work as a medium of exchange wherein individual coin ownership records are stored in a ledger existing in a form of a computerized database.
  • It uses strong cryptography to secure transaction records, control the creation of additional coins, and verify the transfer of coin ownership.
  • It typically does not exist in physical form (like paper money) and is typically not issued by a central authority.
  • Cryptocurrencies typically use decentralized control as opposed to centralized digital currency and central banking systems.

How does it work?

  • Cryptocurrencies work using a technology called the blockchain.
  • Blockchain is a decentralized technology spread across many computers that manage and record transactions.

What is Blockchain Technology?

  • Simply, blockchain is a decentralized, distributed, and public digital ledger.
  • Blockchains are a new type of network infrastructure (a way to organize how information and value move around on the internet) that creates ‘trust’ in networks by introducing distributed verifiability, auditability, and consensus.
  • Blockchains create trust by acting as a shared database, distributed across vast peer-to-peer networks that have no single point of failure and no single source of truth.
  • No individual entity can own a blockchain network, and no single entity can modify the data stored on it unilaterally without the consensus of its peers.

Also read

Cryptocurrency and Regulation of Official Digital Currency Bill, 2021


Back2Basics: Legal Tender Money

  • A legal tender is a coin or a banknote that is legally tenderable for discharge of debt or obligation.
  • Coin of any denomination not lower than one rupee shall be legal tender for any sum not exceeding one thousand rupees.
  • Fifty paise (a half rupee) coins shall be legal tender for any sum not exceeding ten rupees.
  • While anyone cannot be forced to accept coins beyond the limits mentioned above, voluntarily accepting coins for amounts exceeding the limits mentioned above is not prohibited.
  • Every banknote issued by the Reserve Bank of India unless withdrawn from circulation shall be legal tender at any place in India.
  • ₹1 notes issued by the Government of India are also Legal Tender.

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By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Prices, profits and the pandemic: What RBI could do

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Real interest rate

Mains level : Paper 3- Challenge of managing inflationary pressure

The article discusses the challenges in managing the inflationary pressure while ensuring the low interest rates and sufficient liquidity in the covid battered economy.

Growing inflationary pressure

  • As the second wave eases, producers could pass on more cost increases to consumers, pushing up inflation.
  • Inflationary pressures are on the rise, globally and domestically.
  • Real rates in India have moved into the negative terrain and some measures of inflation expectations have begun to rise gently.
  •  WPI inflation was subdued last year during the first wave of the pandemic due to falling global commodity prices.
  • This year is different, as inflationary pressures have surfaced in the WPI.
  • And within WPI inflation, input prices are rising much faster than WPI output prices.
  • Producers do not seem to be passing on much of the rise in raw material costs to output prices, perhaps worried that already uncertain demand could weaken further.
  • After states roll back local lockdowns, the demand for goods and services will gradually picks up, producers may feel more confident about passing on raw material cost increases to output prices, pushing core inflation higher, particularly in the second half of FY22.

RBI’s role: Dealing with impossible trinity?

  • Last year, RBI was faced with conflicting objectives on inflation, bond yields and the rupee, also known as the impossible trinity.
  • It bought dollars to prevent the rupee from strengthening too much and purchased government bonds to keep bond yields from spiralling out of control.
  • But this created excess rupee liquidity in the banking system, which over time can stoke inflation and other financial imbalances.
  • These conflicting objectives are also likely to linger this year, and RBI will have to juggle them carefully.
  • As the year progresses, space could open up for RBI to gradually shift the focus to inflation control.
  • With the current account moving into deficit, the balance of payments surplus is likely to fall, so RBI may not have to purchase as many dollars as last year.
  • The will result in decrease in domestic liquidity and ultimately an important part of the normalization of monetary policy and inflation control.
  • RBI would still need to buy government bonds to support the administration’s borrowing programme.
  •  However, a large carry-over of cash balances could act as a buffer—they totalled 2.5 trillion at the end of FY21, almost double the recent average.
  • This could help fund some of the unbudgeted rise in the fiscal deficit.

Way forward on controlling inflation

  • If the need to buy dollars is lower than last year, RBI could gradually shift the focus to controlling inflation.
  • Starting in 4Q 2021, when the proportion of the population vaccinated will hopefully reach critical mass, RBI need to start reducing the level of surplus liquidity, raise the reverse repo rate, and change its monetary stance to neutral.
  • The aim should be to gradually push up short-end rates towards 4%, so that real rates don’t remain hugely negative for too long.
  • An increase in the benchmark repo rate— currently 4%— can wait, perhaps until there are surer signs that the private investment cycle is rising.

Conclusion

Dealing with the three elements of impossible trinity this time is not as difficult for the RBI as it was last year, it needs to shift focus to inflation control at the opportune moment.


Back2Basics: Real interest rate

  • A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor.
  • The real interest rate of an investment is calculated as the difference between the nominal interest rate and the inflation rate.

Real Interest Rate = Nominal Interest Rate – Inflation (Expected or Actual)

The impossible trinity

  • A theory that states that, in the long-run, a central bank that hopes to conduct independent monetary policy must choose between maintaining a fixed foreign exchange rate and allowing the free movement of capital.
  • For instance, a central bank that chooses to increase the total money supply by adopting loose monetary policy cannot hope to maintain the foreign exchange value of its currency unless it resorts to restricting the sale of domestic currency in the currency market.
  • The idea is derived from the academic works of Canadian economist Robert Mundell and British economist Marcus Fleming.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Maintaining the inflation target at 4%

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Inflation

Mains level : Inflation management

On the last day of the financial year 2020-21, the Finance Ministry announced that the inflation target for the five years between April 2021 and March 2026 will remain unchanged at 4% (+/-2 %).

Inflation targeting in India

  • India had switched to an inflation target-based monetary policy framework in 2015, with the 4% target kicking in from 2016-17.
  • Many developed countries had adopted an inflation-rate focus as an anchor for policy formulation for interest rates rather than past fixations with metrics like the currency exchange rate or controlling money supply growth.
  • Emerging economies have also been gradually adopting this approach.

Try this PYQ:

Which one of the following is not the most likely measure the Government/RBI takes to stop the slide of Indian rupee?

(a) Curbing imports of non-essential goods and promoting exports

(b) Encouraging Indian borrowers to issue rupee denominated Masala Bonds

(c) Easing conditions relating to external commercial borrowing

(d) Following an expansionary monetary policy

What is the rate of consumer price inflation?

  • Moody’s Analytics recently pointed out that volatile food prices and rising oil prices had already driven India’s consumer price index (CPI)-based inflation past the 6% tolerance threshold several times in 2020.
  • While inflation headwinds remain, especially with oil prices staying high, there was some speculation that the Central government may ease up on the inflation target by a percentage point or two.
  • This would have given the Reserve Bank of India (RBI) more room to cut interest rates even if inflation was a tad higher.

What is the RBI’s position on this?

  • The RBI had, in recent months, sought a continuance of the 4% target with the flexible tolerance limits of 2%.
  • The 6% upper limit, it argued, is consistent with global experience in countries that have a large share of food items in their consumer price inflation indices.
  • Accepting inflation levels beyond 6% would hurt the country’s growth prospects, the central bank had asserted.

Why should these concern consumers?

  • The central bank’s monetary policy and the government’s fiscal stance may not have necessarily reacted to arrest inflation pressures even if retail price rise trends would shoot past 6%.
  • As high oil prices spur retail inflation higher, the central bank is unhappy as its own credibility comes under a cloud if the target is breached.
  • If the upper threshold for the inflation target were raised to 7%, the central bank may not have felt the need to seek tax cuts (yet).
  • Thus, the inflation target makes the central bank a perennial champion for consumers vis-à-vis fiscal policies that, directly or indirectly, drive retail prices up.

Back2Basics:

Types of Inflation: Demand Pull, Cost Push, Stagflation, Structural Inflation, Deflation and Disinflation

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

How did inflation targeting really impact India?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : MPC

Mains level : Paper 3- Analysing the performance of inflation targeting policies in India

The article analyses the success of the inflation targeting mechanism in India and its impact on the growth of the economy.

Background of the inflation targeting policy in India

  • It has been three decades since inflation targeting was first adopted in New Zealand and subsequently by 33 other countries.
  • India adopted it in 2016.
  • The primary goal of inflation targeting was to contain inflation at around 4 per cent, within the allowable range of 2 to 6 per cent.
  • The RBI has announced a formal review of the policy instrument now.
  • At the first meeting of the RBI Monetary Policy Committee in October 2016, it was also formally announced that the MPC considered a real repo rate of 1.25 per cent as the neutral real policy rate for the Indian economy.
  • By a neutral real policy rate, the RBI meant a policy rate consistent with growth at potential (i.e. growth at full employment).

Has inflation targeting worked in India

  • The evaluation of IT must provide answers to the following two questions:
  • Did inflation decline post the adoption of inflation targeting and what was the role of IT in the decline in inflation?
  • Was the adoption of inflation targeting associated with the policy of the highest real repo rates in India — ever — for almost three years 2017-2019?
  • The answer is yes to the latter, but it also needs to be acknowledged that high real repo rates were the primary cause of the GDP growth decline in India from 8 per cent to 5 per cent.

Need to take into account the global context of inflation

  • An interesting feature of the Indian defence of inflation targeting is that very few take into account the global context of inflation in which the decline in inflation has occurred in India.
  • A research paper by Balasubramanian, Bhalla, Bhasin and Loungani at ORF evaluates inflation targeting in a global context and separately for Advanced Economies (AEs) and Emerging Economies (EES).
  • Some facts from the paper are the following.
  • First, the annual median inflation in AEs has been consistently low, so low that many central banks have official campaigns to raise the inflation rate.
  • One conclusion might be that IT succeeded beyond anyone’s dreams in these economies.
  • But attributing this decline in inflation to IT would be erroneous.
  • Inflation is global and price-taking by millions of producers in the world means that no one producer or one country can influence the price of any item.
  • Oil has ceased to be a factor in global inflation, at least post the mid-1980s.
  • The lowest inflation in Indian history occurred during 1999-2005, averaged only 3.9 per cent.
  • The average median rate among EM targetters during 2000-04 was 4 per cent, and among the non-targeting countries was 3.8 per cent.

Did fiscal deficit play role in inflation targeting

  • In 2003, India passed the FRBM act to control fiscal deficits and inflation.
  • There is precious little evidence, either domestically or internationally, about fiscal deficits affecting inflation.
  • For three consecutive years preceding the FRBM announcement, the consolidated Centre plus state deficits registered 10.9 per cent(in 2001), 10.4 and 10.9 per cent.
  • For the seven-year 1999-2005 period, consolidated fiscal deficits averaged 9.4 per cent of GDP.
  • Yet, that these years represented the golden period of Indian inflation — without FRBM and without IT.

Cost of inflation targeting in India

  • There are also costs to inflation targeting in India.
  • It led to higher real policy rates, in the mistaken belief that high policy rates affect the price of food, oil, or anything else.
  • But high real rates affect economic growth, by affecting the cost of domestic capital in this ultra-competitive world.
  • It is very likely not a coincidence that potential GDP growth, as acknowledged by RBI, was reached just before the MPC took over decision making in September 2016. 
  •  Since then there was a steady increase in real policy rates, and a steady decline in GDP growth.

Consider the question “How far has the inflation targeting mechanism been successful in India? Give reasons in support of your argument.” 

Conclusion

So, in the inflation targeting mechanism has not been successful in containing the inflation though there had a cost associated with it which we paid in the form of growth.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Challenges ahead for the RBI

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Taper tantrum

Mains level : Paper 3- Challenges ahead for the RBI in withdrawing expansionary policy measures

With the Indian economy showing green shoots, RBI has to face some fundamental challenges while withdrawing the expansionary measures. 

Expansionary policy as a response to pandemic

  • To manage the financial pressures unleashed by COVID-19, the RBI unleashed several measures.
  • It reduced policy interest rates aggressively.
  • It released an unprecedented amount of liquidity in the market.
  • It instituted a slew of measures for targeted assistance to, especially distressed sectors.

Time to roll back the expansionary monetary policy

  • As the Indian economy is showing the signs of recovery, the RBI must be planning for a non-disruptive exit out of the easy money regime.
  • Reversing a crisis-driven expansionary policy has to be a deliberative process, with the timing and sequencing carefully planned.
  • A big lesson of the global financial crisis is that any missteps on the exit path by way of commission, omission, or importantly communication, can be costly in macroeconomic terms.

Challenges RBI will face on the way out of expansionary monetary policy

1) Restraining inflation while supporting the recovery

  • Inflation remained above the RBI’s target band for the past several months.
  • According to the RBI’s own estimates, inflation is expected to remain above the band for the next several months.
  • Yet, the MPC, in its recent review, decided against any rate action out of concerns for growth and financial stability.
  • The MPC expects inflation to soften on its own in the weeks ahead.
  • That outcome is not inevitable.
  • Inflation could be pressured upwards by several factors even though there could be some apparent softening purely because of base effects.
  • There is the risk that persistent high inflation expectations would result in food inflation getting more generalised.
  • Core inflation could firm up because of rising input prices.
  • ‘Excessive margins’, among the factors cited by the MPC as one of the causes of high inflation, may not disappear.
  • Equally, there are concerns that the recovery, for all the positive signals, is still fragile. 
  • And there is heightened concern about an aggravated unemployment problem caused by big firms retrenching labour to cut costs.

2) Impact on savings

  • RBI should also be concerned about the plight of savers who are being shortchanged by low-interest rates at a time of high inflation.
  • Low-interest rates, its impact on inflation and economic recovery taken together make a complex cocktail of dilemmas for the RBI as it seeks to normalise the policy rates.

3) Withdraw excess liquidity at right time and to avoid ‘taper tantrum’

  • Another related challenge will be to withdraw the ‘excess’ liquidity in good time.
  • Banks are routinely depositing trillions of rupees with the RBI every day, evidencing that all the money that the central bank injected into the system is not doing much good anymore.
  • Every financial crisis can be traced back to mispricing of risk.
  • Mispricing of risk results when there is too much liquidity sloshing around the system for too long.
  • It will drive investors into dodgy ventures and threaten financial stability.
  • As the RBI seeks to guard financial stability by normalising liquidity, it will have to contend with possible market tantrums.
  • The lesson from the taper tantrums in the U.S. is that the RBI will have to manage its communication as carefully as it does the liquidity withdrawal.

4) Stability of the rupee

  • Next challenge for the RBI will be to restrain the rupee from appreciating out of line with fundamentals.
  • Here, the RBI is confronted with a classic case of ‘the impossible trinity’.
  • The impossible trinity deals with allowing free capital flows while simultaneously maintaining a stable exchange rate and restraining inflation.
  • The current account surplus this year together with massive capital flows has meant an excess of dollars in the system putting upward pressure on already overvalued rupee.
  • The RBI has absorbed nearly $90 billion this fiscal year to prevent exchange rate appreciation and to maintain the competitiveness of the rupee.
  • The RBI’s ability to continue to intervene in the forex market will be constrained by its anxiety about how the resultant liquidity might aggravate inflation and the risk to financial stability.

Consider the question “What are the challenges ahead for the RBI while winding down the expansionary monetary policy measures that were announced to deal with the economic disruption of caused due to pandemic and subsequent lockdown.

Conclusion

It is better to be rough right, as Keynes said, than be precisely wrong. That should be the guiding principle for RBI as it navigates its way out of the crisis driven easy money policy.


Back2Basics: What is taper tantrum?

  • Taper tantrum refers to the 2013 collective reactionary panic that triggered a spike in U.S. Treasury yields, after investors learned that the Federal Reserve was slowly putting the breaks on its quantitative easing (QE) program.
  • The Fed announced that it would be reducing the pace of its purchases of Treasury bonds, to reduce the amount of money it was feeding into the economy.
  • The ensuing rise in bond yields in reaction to the announcement was referred to as a taper tantrum in financial media.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

RBI keeps repo rate unchanged

Note4Students

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.

Conclusion

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.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Reinforcing the RBI’s accountability

Note4Students

From UPSC perspective, the following things are important :

Prelims level : MPC and inflation targets

Mains level : Paper 3- Inflation targeting by the RBI

Inflation targeting and legal provisions

  • The inflation target, notified in August 2016, is 4%.
  • The upper tolerance level was set at 6% and the lower tolerance level at 2%.
  • Inflation was 6.7% in the January-March quarter, 6.6% in the April-June quarter and 6.9% in the July-September quarter.
  • Breaching limits for any three consecutive quarters constitutes a failure to achieve the inflation target.
  • In such an event, the Reserve Bank of India (RBI) is required to send a report to the Centre, stating the reasons for the failure to achieve the inflation target, the remedial actions it proposes to initiate, and an estimate of the time-period within which it expects to achieve the inflation target through the corrective steps proposed.
  • Through amendments passed by Parliament in 2016, these new provisions were written into the RBI Act.
  • They are aimed at ensuring enhanced transparency and accountability of the central bank.

Reason given by the RBI for missing the target

  • The normal data collection exercise of the National Statistics Office was disrupted during the lockdown imposed due to the COVID-19 pandemic.
  • The minutes of the Monetary Policy Committee (MPC) meeting after its August policy review suggest that the RBI’s defence for the breach of the 4% inflation target and 6% upper tolerance limit was the handicap of data limitations.

Issues with the reason given by the RBI

  • The range around the inflation target that the Ministry provided to the RBI is for accommodating constraints and challenges like data limitations.
  • The whole point of the range around the target, the statement emphasised, is that it “accommodates data limitations, projection errors, short-run supply gaps and fluctuations in the agriculture production”.

Way forward

  • RBI should be made to explain what it plans to do to control inflation.
  • The central bank should be allowed to state expressly what support by way of government policy it needs to meet the inflation target.
  • This can only strengthen the RBI’s hand; it should not let go of the opportunity to reinforce the MPC framework.

Conclusion

Transparency can enable more informed decision-making within the government, greater public scrutiny of the RBI’s performance, and an improved inflation-targeting regime. To slack off on it would be to compromise with the credibility, transparency and predictability of monetary policy.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

The RBI tunes in to the economy

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Inflation targeting mechanism

Mains level : Paper 3- Issues with the inflation targeting mechanism of the RBI

The article analyses the recent changes signalled by the RBI in its policymaking.

Changes in the economic policymaking

  • Recently the U.S. Fed declared that the Fed will not let inflation stand in the way of maximising employment.
  • The reason for this was that the Phillips Curve, the relationship between inflation and unemployment, may no longer hold in the U.S. economy.
  • This is significant, given that the Anglo-American economics has been dominated by Phillips Curve.

Why there was need for change in inflation targeting

  • Data show that the model that currently guides India’s inflation control strategy may be quite irrelevant.
  • This is seen in the recent behaviour of inflation.
  • We know that output contracted by more than 23% in the first quarter of this year.
  • Despite this staggering decline the inflation rate did not change,
  • This was contrary to experience that inflation reflects an ‘over heating’ economy, one growing too fast in relation to its potential.
  • This view represents the RBI’s official understanding of inflation, and presumably forms the basis of its policy of inflation targeting.
  • It was endorsed by the Government of India when it legislated the modern monetary policy framework to enable the RBI to pursue inflation targeting.
  • If the Phillips Curve, which the RBI’s approach internalises, exists, inflation should have decreased as India’s economy contracted during the lockdown.
  • The current inflation targeting mechanism had been imagined with developing economies in mind.
  • Inflation targeting mechanism is based on the idea that food prices are an important determinant of inflation along with imported inflation.
  • Accordingly, a macroeconomic contraction need not lower inflation.

Role of food prices in India

  • A recent working paper of the RBI’s research department suggested that a more eclectic model than the one that underlies inflation targeting does a better job of forecasting inflation in India.
  • This model accepts a role for food prices, a possibility that is missed when embracing economic models developed in the western hemisphere, where food prices have stopped trending upwards over half a century ago.

Conclusion

The RBI shifting away from its rigid inflation targeting policy is in tune with the time and signals that the central bank is finally alive to India’s economy.


Back2Basics: What is Philips Curve?

  • The Phillips curve is an economic concept, stating that inflation and unemployment have a stable and inverse relationship.
  • The theory claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment.
  • However, the original concept has been somewhat disproven empirically due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Dilemma the RBI faces

Note4Students

From UPSC perspective, the following things are important :

Prelims level : MPC

Mains level : Paper 3- Role of the RBI and contradictions in its functions

Limitations and contradictions in the functioning of RBI

  • The Reserve Bank of India, along with the monetary policy committee, has undertaken measures to address the fallout of the COVID-19 pandemic.
  • Their actions are guided by multiple considerations — inflation and growth management, debt management and currency management.
  • These multiple considerations have inadvertently exposed the limitations of and the inherent contradictions in the central banking framework in India.

Monetary policy functions

  • The MPC is guided by the goal of maintaining inflation at 4 plus/minus 2 per cent.
  • In its August policy, despite dire growth prospects, MPC chose to maintain the status quo.
  • This decision was driven by elevated inflation i.e. above 4 plus/minus 2 per cent. 
  • This raises the question: At the current juncture, should the MPC be driven by growth considerations or should short-term inflation concerns dominate?

Understanding the nature of current inflation

  • The current rise in inflation is driven by supply-chain dislocations owing to the lockdowns.
  • This is evident from the growing disconnect between the wholesale and consumer price index.
  • Since April, while WPI has been in negative territory, CPI has been elevated.
  • The MPC’s mandate is to deliver stable inflation over long periods of time, not just a few months.
  • Yet, it would appear as if it is more concerned about elevated inflation in the short run.
  • Equally puzzling is the refusal of MPC to provide any firm projection of future inflation.

Manager of government debt

  •  As manager of the government debt, the RBI is tasked with ensuring that the government’s borrowing programme sails through smoothly.
  • To this end, it has carried out several rounds of interventions popularly known as operation twist.
  • in operation twist government RBI intended pushing down long-term Gsec yields, and exerting upward pressure on short-term yields as a consequence.
  • In doing so, the RBI ended up doing exactly the opposite of what the MPC was trying to achieve by cutting short term rates, well before it reached the lower limit of its conventional policy response.

3) RBI’s intervention in currency markets

  • The RBI’s interventions in the currency market have constrained its ability to carry out open market operations as these would have led to further liquidity injections into the system.
  • Put differently, its debt management functions have run up against its currency management functions.
  • Underlining the complexity of all this is the talk of sterilisation — the opposite of injecting liquidity in the system.

Consider the question “RBI’s functions at the current juncture suffers from contradicting functions. Examine such contradictions in its role and suggest the ways to avoid such contradictions.”

Conclusion

The central bank must develop a clear strategy on what to do. At this juncture, there is a strong argument to look past the current spurt in inflation, and test the limits of both conventional and unconventional monetary policy. At the other end, while it may want to intervene to prevent the rupee’s appreciation, in doing so, it is constricting its debt management functions which will have its own set of consequences. There are no easy answers.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Monetary Policy Committee (MPC) to meet 5x this Fiscal

Note4Students

From UPSC perspective, the following things are important :

Prelims level : MPC and its various tools

Mains level : Not Much

The rate-setting Monetary Policy Committee (MPC) will be meeting five times in FY21, against seven in FY20.

Monetary Policy tools are all-time favourites of UPSC. Kindly go through the link given in the Back2Basics section.

Monetary Policy Committee (MPC)

  • The Monetary Policy Committee (MPC) is a committee of the RBI, which is entrusted with the task of fixing the benchmark policy interest rate (repo rate) to contain inflation within the specified target level.
  • The RBI Act, 1934 was amended by Finance Act (India), 2016 to constitute MPC to bring more transparency and accountability in fixing India’s Monetary Policy.
  • The policy is published after every meeting with each member explaining his opinions.
  • The committee is answerable to the Government of India if the inflation exceeds the range prescribed for three consecutive months.
  • Suggestions for setting up a Monetary policy committee is not new and goes back to 2002 when YV Reddy committee proposed to establish an MPC, then Tarapore committee in 2006, Percy Mistry committee in 2007, Raghuram Rajan committee in 2009 and then Urjit Patel Committee in 2013.

Composition and Working

  • The committee comprises six members – three officials of the RBI and three external members nominated by the Government of India.
  • The meetings of the Monetary Policy Committee are held at least 4 times a year and it publishes its decisions after each such meeting.
  • The Governor of RBI is the chairperson ex officio of the committee.
  • Decisions are taken by a majority with the Governor having the casting vote in case of a tie.
  • They need to observe a “silent period” seven days before and after the rate decision for “utmost confidentiality”.

Back2Basics

Monetary Policy tools and Money Supply in India

 

Also read:

How reverse repo rate became benchmark interest rate in the Indian economy?

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] Operation Twist

Note4Students

From UPSC perspective, the following things are important :

Prelims level : OMO

Mains level : OMO - effectiveness

Context

The Reserve Bank of India announced its decision to conduct simultaneous purchase and sale of government securities for Rs 10,000 crore each, under Open Market Operations (OMO). 

The need of the hour

  • This is done after a review of the current liquidity, market situation and evolving financial conditions.
  • Similar to past US experiments – Financial markets perceive this as an Indian variant of Operation Twist. This is said to be similar to the asset purchase programme kicked off by the Kennedy administration in the US in 1961 and later in 2011 by the US Federal Reserve to help lower long-term interest rates.

OMO

  • It is an instrument of monetary policy aimed at either withdrawing liquidity or boosting it, including during periods of robust capital flows.
  • Objective – The aim is to influence long-term interest rates and also to provide a boost to the economy by making the cost of capital or funds cheaper for business and industry and other borrowers.
  • Such programmes were launched in the US first during a recession and later during a prolonged slowdown.
  • Reason – Even after aggressively cutting its policy rate by 135 basis points this year, monetary policy transmission has been weak. Banks are not lowering rates significantly given the state of their balance sheets.
  • Need for complementary support – for such a programme to have an impact, there should be a well functioning market for government securities with depth. 
  • Poor financial sector – the link between India’s bond market and the real economy has been relatively weak and making it worse is a half functional financial sector now.
  • Fiscal performance – the large fiscal slippage — the fiscal deficit at the end of April-October this year at above 100% of the budgeted target — the spike in inflation and toned down projections of GDP growth. 
  • Lessons from the US experience – a programme aimed at reducing long-term bond yields will only have limited impact as long as the government runs a large deficit.

Way ahead

  • There is a growing recognition that central banks are running out of ammunition. 
  • The government should get to work on a credible fiscal deficit reduction plan.
  • It should fix the broken financial system along with unveiling a roadmap for state-owned banks.
  • The divestment programme should get going.
  • The packages for sectoral issues, especially real estate, should be operationalised swiftly.

Back2Basics

Open Market Operations

Economics | Monetary Policy Explained with Examples

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] Trouble with credit

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Slowdown of credit in the economy

Context

The Monetary Policy Report of the RBI paints a worrying picture of credit flows in the economy. 

Status of credit flows

  • Between April and mid-September this year, the flow of funds to the commercial sector collapsed to Rs 90,995 crore, down from Rs 7.36 lakh crore over the same period last year. 
  • Non-food bank credit has declined
  • Flows from NBFCs have declined. 
  • Foreign flows have picked up during this period. 
  • Typically, credit flows in the first half of the year tend to be subdued and pick up in the second half. The decline this time around compared to the previous year is staggering.

Reasons behind this decline

    • It appears to be due to a combination of two factors 
      • a collapse in demand
      • risk aversion

Corporate investments

    • An over-leveraged corporate sector is in the midst of a much needed deleveraging exercise. 
    • In the current environment of subdued demand and low capacity utilisation rates, there is little incentive to launch fresh investments.

Banks

    • On the other hand, banks appear to be reluctant to cut rates to boost lending.
    • They are parking more funds in government securities and with the RBI.
    • RBI report notes that banks have increased their SLR portfolios, holding excess SLR of 6.9% at the end of August 2019 indicating a reluctance to lend.
    • In the face of growing economic uncertainty, banks have tightened credit norms, reducing those eligible for credit.
    • The shift in the liquidity stance from deficit to surplus mode has also not helped boost credit flow to the larger economy. 

Crisis in the NBFC 

      • This has only deepened. 
      • Bank credit and the commercial paper market remains shut for NBFCs.
      • Credit flow from NBFCs to the larger economy has suffered and the fallout is visible in the decline in household debt fueled consumption.

Conclusion

  • A slowdown in economic activity will increase stress on the repayment capacity of borrowers and increase the rise of default, making lenders even more cautious. 
  • The first step towards rebuilding trust, and addressing the stress in the financial sector in order to get credit flowing, should be to ensure a quick and orderly resolution of stressed NBFCs.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] A welcome move, but it’s unlikely to spur demand

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Monetary policy rate cut

Context

With the 25 basis points (bps) rate cut, RBI returned to the conventional wisdom of a rate change in multiples of 25bps.

RBI statement

    • MPC decided to continue with an accommodative stance as long as it is necessary to revive growth while ensuring that inflation remains within the target.
    • RBI’s decision to increase the household income limit for borrowers of NBFCs and MFIs is welcome. It will enhance credit delivery to a larger customer base at the bottom of the pyramid.
    • There is an attempt to boost the domestic forex derivatives market. RBI has decided to allow domestic banks to offer foreign exchange prices to non-residents on a 24-hour basis. 

Efficacy of rate cuts

    • This may push the debt markets to take a cue from the second-generation policy signals and yields may soften from the current level.
    • Efficacy of rate cuts is questionable against elevated household leverage, deteriorating company fundamentals, and weak demand
    • The number of downgrades in H1FY20 grew by 66% vis-à-vis a 20% de-growth for the number of upgrades. The pace of downgrades has been increasing. 
    • Financial flows to the commercial sector in H1FY20 are significantly lower due to a decline in funding from banks and non-bank sources. 
    • Despite a rising interest scenario, credit had expanded by over ₹1.65 trillion but contracted by ₹93,700 crores even as we are in an aggressive rate cut cycle. This indicates credit risk aversion continues to play center stage for the non-bank sector.

Fiscal policy

    • Centre has done a remarkable job in maintaining fiscal consolidation.
    • We are increasingly concerned about the fiscal position of the states. 

Way ahead

    • More clarity is needed to crystallize the KYC requirements for off-shore entities as also their tax implications.
    • In the current context, an only monetary policy rate cut would not work in isolation. It must be complemented by fiscal expansion.

Back2Basics

Foreign exchange derivative

A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange rate of two currencies.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] Fiscal wheels must also roll in order to make monetary policy effective

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Monetary policy transmission

CONTEXT

Through four successive reductions in this calendar year, RBI has reduced the repo rate by 110 basis points to 5.4%.

Status of the rate cut

  1. The economy has been slow to respond to these incremental monetary stimuli. 
  2. Quarterly growth data show a continuing slowdown, mainly driven by sluggish demand, due to both external and domestic factors.
  3. There is substantial excess capacity in the manufacturing sector.
  4. With unutilized capacity, temporary and casual employees are being laid off and wage hikes are being postponed, reducing levels of aggregate disposable income, which is further reducing demand, particularly for consumer durables.
  5. Unless capacity utilization improves, investment demand from the private sector is not likely to improve. 

Repo rate reductions only provide enabling conditions to reduce the cost of borrowing. To be effective, adequate transmission needs to take place.

Limitations of Monetary Policy

  1. Demand for investment and consumer durables has to increase, which is a function of income, much more than the cost of borrowing. For this, momentum has to be generated at the fiscal side.
  2. Due to revenue constraints and legislative limits on borrowing, suitable countercyclical fiscal measures have not yet been taken.
  3. Public sector investment has been showing signs of stagnation for some time. The central government’s capital expenditure to GDP has stagnated at 1.6% for 2018-19 and 2019-20 as budgeted.
  4. Without a demand push from the public sector, monetary policy alone would not be effective.

What the government should do

  1. The countercyclical policy is primarily the responsibility of the central government. 
  2. A one-year departure from the budgeted fiscal deficit of 3.3% of GDP for 2019-20 can be justified at the current juncture.
  3. It should be ensured that the entire additional borrowing above the budgeted level is spent on capital expenditure.
  4. It is established fact that increases in government capital expenditures have much larger multiplier effects, as compared to increases in government revenue expenditures.
  5. State governments and the central and state public enterprises should come on board and undertake additional investment spending on infrastructure.
  6. This will push investment from the private sector, uplifting the infrastructure and construction sectors, and later spreading out to other sectors.
  7. This will trigger a virtuous cycle focused on the employment-intensive infrastructure and construction sectors -> private disposable incomes would increase -> reversing the ongoing demand slow down.
  8. As the magnitude of private borrowing grows, the transmission would improve.

Together, the joint impact of the fiscal and monetary stimuli is expected to uplift the country’s growth from its present low level to levels comfortably above 7% and, eventually, closer to 8.5-9%. Sustaining growth at these levels is required if India were to become a $5-trillion economy by the end of FY25.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] The capital adequacy norms for banks could do with revision

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Problems with monetary policy transmission


Context

The monetary policy committee of RBI will announce its monetary policy decision. RBI is widely expected to cut rates.

Challenges in Monetary policy transmission

  1. Irrespective of the magnitude of a rate cut, the question of transmission is a big one.
  2. Interest rate cuts take much longer to be passed on.
  3. It is not even clear if interest rates matter in the current uncertain environment. 

Risk weights

  1. In the credit boom years up to 2007, RBI had proactively adjusted risk weights to dissuade banks from lending excessively to certain sectors and businesses.

Why reverse now

  1. According to data published by the Bank for International Settlements (BIS), India’s credit-to-GDP gap has been negative since 2013 and is now running well below trend.
  2. Banks are unwilling to lend and businesses are not keen to borrow either. The caution of banks should not starve creditworthy borrowers.
  3. In the post-2008 phase, regulators around the world have embraced counter-cyclical capital buffers and macroprudential norms to better regulate credit creation while interest rates hit new lows. RBI could use the mechanism of countercyclical capital buffers to ease credit conditions.
  4. Act in concert with owners of banks in enforcing lending discipline.
  5. Central bank prescribing the MCLR-based lending rate as the floor in a liberalized interest rate environment is incongruous.
  6. The government must use the crisis to legally enshrine non-interference in the operational decisions of banks
  7. The government must incentivize banks to augment their assessment of creditworthiness and risk assessment of loans on a continuous basis.
  8. Capitalization support and operational autonomy must be made contingent on skill up-gradation and other quantifiable performance measures.
  9. As economic conditions normalize, countercyclical capital buffers must and will move in the opposite direction.
  10. The bigger question is whether the capital adequacy norms prescribed under Basel III should be made uniformly applicable to all banks in India or only to internationally active banks. It will not only reduce the capitalization burden on the government but will also free up lending capacity.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] The misplaced faith in an easy money policy

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Monteary Policy basics

Mains level : Limitations of monetary pollicy

CONTEXT
The reaction of global markets to the US Federal Reserve’s monetary stance suggests investors are vesting too much faith in easy money to promote investment and growth.

Why the emphasis on monetary policy

  1. RBI does have more leeway to reduce its repo rate now that the Fed has lowered its own lending rate in the US by a quarter percentage point
  2. An RBI rate cut may stem the slide in stock prices, but this can be rationalized only by virtue of the signal it sends of RBI’s intent to aid a sluggish economy, not for a quick revival

Limitations of monetary policy

  1. There is evidence to suggest that the efficacy of monetary policy is diminishing.
  2. In the West, this is largely because the cost of capital is already very low by historical standards
  3. Much cheap credit goes into chasing higher-paying assets around the world instead of spurring business activity
  4. In India, monetary policy is even less potent in spurring investment. Various other factors beyond the cost of capital act as a drag.
  5. Of the three- quarters of a percentage point reduction in RBI’s repo rate this year, banks have passed on barely half
  6. With consumption on a downtrend, the will of companies to borrow and invest is weak

Way ahead

  1. What might restore market sentiment are renewed inflows from abroad into Indian shares and securities set off by the Fed’s move
  2. Infrastructure spending spree
  3. Implementing a set of major reforms that allow market forces to play an effective role in most of the arenas
  4. Easing land acquisition rules and turning the country’s labour market flexible could have a dramatic effect on India’s appeal as an investment destination
  5. Reversal of some income tax rules seen as extortionary by rich investors 
  6. LTCG tax could be given a rethink

It is a good time for reforms. Let’s not over-rely on monetary policy.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

RBI has cut lending rates for the third consecutive time

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Repo and Reverse Repo

Mains level : Monetary policy decisions

  • The RBI has reduced the repo rate by 25 basis points (bps) to 5.75 per cent in the second bi-monthly monetary policy meet of the financial year 2019-20 (FY20).
  • It was a third straight interest rate cut by the RBI’s monetary policy committee (MPC).

What is Repo Rate?

  • REPO denotes Re Purchase Option – the rate by which RBI gives loans to other banks.
  • In other words, it is the rate at which banks buy back the securities they keep with the RBI at a later period.
  • Bank gives loan to the public at a higher rate, often 1% higher than REPO rate, at a rate known as Bank Rate.
  • RBI at times borrows from banks at a rate lower than REPO rate, and that rate is known as Reverse REPO rate.

Why has RBI cut repo rate

  • The RBI was widely expected to go for an interest rate cut amid dismal gross domestic product (GDP) growth, subdued investment and slowdown in consumption space.
  • Last week, government data showed GDP growth slowed to a five-year low of 5.8 per cent in the fourth quarter (Q4) of FY19.
  • Weak growth amid benign CPI inflation had created room for the Monetary Policy Committee to cut the repo rate by 50-75 bps through FY20E, beginning in June 2019.

Concern over the cut

  • The big concern is whether the transmission of the cut takes place adequately, in the sense of banks passing in the rate cut to customers.
  • This has not happened sufficiently in the case of the previous cuts.

Back2Basics

Monetary Policy Committee

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] No surprises

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Repo Rate

Mains level : RBI through rate cut is trying to address slowdown in growth as well as keeping inflation in check.

CONTEXT

There was 25 basis points cut in benchmark interest rates by the Reserve Bank of India in its first bi-monthly policy statement of the financial year announced on Thursday.

Need for Cut and basis of cut

  • The market had anticipated such a cut and the only question was whether the central bank would surprise with a deeper 50 basis points cut.
  • In the event, the Monetary Policy Committee (MPC) seems to have decided to hold its horses and settle for a conservative approach given the divergent sets of data that it was confronted with.

1.Fluctuating Inflation Rate

  • On the one hand, inflation, despite the mild spike in February, is well under control at 2.6% and is projected to average 3.2% to 3.4% in the first half of 2019-20.
  • This is below the 4% target set for the MPC.

2.Factors influencing Inflation

  • But there are some factors that could spring a surprise on the upside, such as the behaviour of the monsoon and the trend in global oil prices, both of which feed directly into inflationary expectations.
  • Early forecasts indicate a strong possibility of a below-normal monsoon due to El Niňo. Such an event would cast a shadow on agricultural output, and consequently the food prices.
  • Similarly, global oil prices are now edging close to the $70 a barrel mark on the back of production cuts by the OPEC cartel.
  • While the soft growth trends in the global economy could act as a check on any runaway increase in oil prices, the chances of a sharp fall in the next few months appear remote at this point in time.
  • If these are points of upward pressure on inflation, on the other side growth has been faltering in the last few months, going by both data on industrial output and overall GDP.

Slowdown in growth rate

  • The Central Statistics Office has revised the GDP growth for 2018-19 downwards to 7% while the RBI has projected a lower growth of 7.2% in 2019-20 compared to the 7.4% estimated in the last policy.
  • The 25 basis points cut is, therefore, an acknowledgement by the MPC of the slowdown in growth.

Policy Shift

  • It also signals a shift in policy since Shaktikanta Das assumed office as Governor of the RBI, whereby the MPC is not solely focussed on inflation but also takes into account growth trends with equal seriousness.
  • The MPC’s neutral policy stance is prudent given the uncertainties ahead as it gives the central bank the flexibility to tailor policy to emerging data sets.

 

Conclusion

Meanwhile, New Governor has sent out a welcome, clear signal on the central bank’s commitment to the framework for resolution of stressed assets in the backdrop of the Supreme Court striking down its circular issued on February 12, 2018. While underlining that the RBI’s powers have not been compromised, he has indicated that the central bank will soon reissue the circular taking into account the apex court’s observations. This is as it should be.

 

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

RBI cuts Repo Rate

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Repo and Reverse Repo

Mains level : Monetary Policy of the RBI

  • The RBI cut its repo rate, or the rate at which it lends to banks, by 25 basis points to 6 per cent.

What is Repo Rate?

  • REPO denotes Re Purchase Option – the rate by which RBI gives loans to other banks.
  • In other words, it is the rate at which banks buy back the securities they keep with the RBI at a later period.
  • Bank gives loan to the public at a higher rate, often 1% higher than REPO rate, at a rate known as Bank Rate.
  • RBI at times borrows from banks at a rate lower than REPO rate, and that rate is known as Reverse REPO rate.

Why a cut?

  • The key consideration for the RBI has shifted from inflation to growth and analysts are betting on the lower inflation rate as well as slower growth in the economy to spur the decision to slash rates.
  • In its last policy review in February, the MPC had shifted the monetary policy stance to ‘neutral’ from ‘calibrated tightening’.

Implications for Consumers

  • For retail consumers, a cut in rates could have a two-pronged impact. For depositors, new deposits will earn a lower rate and thereby lower returns.
  • For borrowers, though, a downward movement of interest rate would bring down the interest outgo in the near future.

Back2Basics

Monetary Policy Committee

Monetary Policy Committee

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap]Ease the flow

Note4Students

Mains Paper 3: Economic Development| Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

From UPSC perspective, the following things are important:

Prelims level: Basic knowledge of RBI’s open market operations.

Mains level: The news-card analyses the reasons for high interest rates its implications over the economy, in a brief manner.


NEWS

CONTEXT

RBI’s tight monetary policy has kept real interest rates high, impacting investment flow and job creation.

High Interest Rates

  • Between January 2018 and January 2019, India’s consumer price inflation has fallen from 5.07 per cent to 2.05 per cent, year-on-year.
  • Yet, the State Bank of India’s MCLR or marginal cost of funds-based lending rate for three years has gone up from 8.10 per cent to 8.75 per cent.
  •  ICICI Bank, likewise, has raised its MCLR for one year from 8.2 per cent to 8.8 per cent.
  • Even yields on 10-year government of India bonds have fallen only marginally from 7.67 per cent to 7.37, despite inflation sliding so sharply.

Impact on Growth

  •  We have today are very high “real” rates of interest.
  • If businesses are borrowings at not less than 9 per cent — micro, small and medium enterprises would obviously be paying much more — when inflation, whether based on the consumer or wholesale price index, is below 3 per cent, it is something serious.
  • During 2012-13 and 2013-14, consumer price inflation averaged 9.7 per cent, whereas benchmark prime lending rates ranged at 9.75-10.25 per cent.
  • Average consumer inflation has come down to 3.6 per cent in 2017-18 and 2018-19 (till January 2019).
  • High real interest rates for a prolonged period is why investments have slowed down and very few jobs are being created.

Reasons for high interest rates

  • The source of it has been the RBI’s tight monetary policy. 
  • A firm commitment to low inflation and macroeconomic stability helped restore investor confidence badly dented during the loose fiscal and monetary policies.
  • But the tightening has gone on for too long.

Way Forward

  • The RBI should cut its overnight lending or “repo” rate in the next policy review meeting in April.
  •  It can even go in for a 0.5 percentage point reduction, instead of the usual 25 basis points.
  • The central bank could also consider more open market operations to bring down bond yields across all maturities. 
  • The government, too, should slash interest rates on the Employees Provident Fund, small savings and other administered schemes.

 

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] Growth prop On RBI repo rate cut

Note4Students

Mains Paper 3: Economic Development| Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

From UPSC perspective, the following things are important:

Prelims level: Basic knowledge of RBI’s open market operations.

Mains level: The news-card analyses the recent rate cut by RBI and its implications over the economy, in a brief manner.


Context

  • The RBI has recently cut the benchmark repo rate.
  • However, concerns over the fiscal deficit remains.

Change of stance

  • Barely four months after the Reserve Bank of India switched its monetary policy stance to one of ‘calibrated tightening’, signalling interest rates were set to trend higher, it has reversed direction.
  • Not only did the RBI’s monetary policy committee unanimously opt to revert to a ‘neutral’ posture, but the rate-setting panel unexpectedly decided, by a 4-2 majority, to cut the benchmark repo rate by 25 basis points, to 6.25%.

MPC’s reasoning has been fairly straightforward

  • With Consumer Price Index-based inflation having continued to slow and projected to stay well below the medium-term target of 4% till at least the October-December quarter, the MPC saw an opportune moment to pivot to a growth-supportive stance.
  • That there is a need to bolster economic momentum is evident from the RBI’s downward revision of the forecast for growth in the first half of the next fiscal year.
  • The projection has been lowered to a range of 7.2-7.4%, from 7.5% posited in the RBI’s December statement, as moderating global growth and slowing overseas demand add uncertainties to the prevailing domestic imbalances.
  • Specifically, production and import of capital goods, which is a key gauge of investment demand, contracted in November/December and credit flows to industry remain muted.
  • With an overall shortfall of 4% in rabi sowing across various crops, and storage in major reservoirs at just 44% of the full level, the slowdown in farm output growth may end up being more protracted.

Weakening of demand

  • The less-than-sanguine outlook for the rural economy is also reflected in the high-frequency indicators of the services sector.
  • Data on sales of both motorcycles and tractors in December underscore weakening demand in the hinterland.
  • This weakness in the farm sector is undergirding the unprecedented softness in food prices.
  • The December CPI data showed continuing deflation in food items.

MPC’s acknowledgment

  • While the RBI’s inflation calculus clearly benefits from the ongoing trend in price gains, the MPC is justifiably cognisant of the tenuousness of the assumptions it has made for its forward projections.
  • Importantly, while it has assumed a normal monsoon this year, the central bank acknowledges that any variation in geographic spread or uneven distribution in terms of time could roil the inflation outlook.

Way Forward

  • However, the RBI’s policy statement fails to make any mention of its hitherto abiding concern about fiscal prudence.
  • With the Interim Budget showing some slippage from the fiscal roadmap and projecting a budget deficit of 3.4% for both the current financial year and the next, the risk of government borrowing crowding out private investment demand remains tangibly real.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] No easy transfer

Note4students

Mains Paper 3: Indian Economy| Issues relating to planning, mobilization of resources, growth, development and employment.

From UPSC perspective, the following things are important:

Prelims level: fiscal stimulus, fiscal policy

Mains level: The newscard discusses impact of easing — fiscal, monetary, and regulatory, on the Indian economy, in a brief manner.


Context

  • Rising agrarian distress and the (chronic) headwinds confronting small and medium enterprises (SMEs) have taken center stage.
  • Extrapolating from this, some are fearing a more generalised and sustained slowdown.
  • This has inevitably led to calls for some easing — fiscal, monetary, regulatory.

Background

  1. The economic narrative in India has rapidly evolved. As recently as October, the policy was focused squarely on preserving macroeconomic stability as external imbalances rose to unsustainable levels and the rupee came under relentless pressure.
  2. With global crude prices collapsing since then and domestic food prices remaining exceptionally benign, stability concerns have receded.
  3. The agrarian distress has already resulted in 10 states announcing farm loan waivers over the last two years.
  4. Now, there is a growing clamour among commentators to introduce unconditional cash transfers to serve as income support for distressed farmers nationally, as has been attempted in Telangana and Odisha.

Dangerous path to tread

  1. First, fears of a growth slowdown are overstated. Near-term prospects have meaningfully improved, as crude prices have collapsed, monetary conditions have eased, and banks have quickly stepped in to fill any void left by non-bank-financial-companies (NBFCs).
  2. Second, bond yields have fallen by almost 70 bps from their highs and, even accounting for some increase in NBFC spreads, monetary conditions have eased to a two-year low.
  3. Third, non-food bank credit growth has picked up sharply, accelerating to a four-year high of 14 per cent, suggesting banks are quickly and increasingly stepping in to fill some of the NBFC voids.
  4. Finally, while the collapse in food prices hurts farmers’ purchasing power and rural consumption, it helps urban consumption.

Amid rising capacity utilisation and the firming of core inflation recently, easing would simply exacerbate underlying imbalances and sow the seeds of future macroeconomic instability.

  1. Fiscal exhaustion
  • The total public sector borrowing requirement (Centre, state, off-balance sheet, central public sector enterprises) was still a hefty 8.2 per cent of GDP in 2017-18.
  • Although, the Centre has been bringing its deficit down, but this has been completely offset by state deficits, off-balance sheet borrowing, and central public sector-enterprise borrowing rising commensurately.
  • Unsurprisingly, this has led to fiscal exhaustion among markets. The slope of India’s government yield curve has continuously risen in recent years.
  • The implication is clear: Any fiscal relaxation at this point will become counter-productive, pushing up borrowing costs and crowding out economic activity.
  1. Fiscal imbalances vis-à-vis external counterpart
  • The current account deficit (CAD) is simply an economy’s investment-savings gap. Public dis-savings remain elevated. Therefore, the main reason the CAD narrowed is because private investment slowed so sharply.
  • If the private investment cycle picks up — as we all hope — the CAD would balloon, unless the public-sector imbalance reduces.
  • In other words, without more fiscal consolidation, we will always be choosing between a sustainable CAD and higher private investment.

The policy challenge

  1. There is absolutely no space for new unfunded liabilities. The pace at which farm loan waivers have been proliferating is worrying, even though budgetary allocations have been much lower than announcements.
  2. As is well known, loan waivers are a particularly blunt instrument suffering from the familiar pitfalls of vitiating credit culture, addressing the symptom, not the underlying cause, and disproportionately favouring larger farmers who rely on institutional credit.

Impact of Proposed direct, unconditional, cash transfers as income support for farmers

  1. A variety of proposals have been mooted from paying farmers the difference between market prices and minimum support prices (MSPs) in cash, to a broader quasi-universal basic income that covers 25-50 per cent of the population, costing anywhere from 1-5 per cent of GDP based on their expansiveness.
  2. The question is how will this be paid for, given that India’s fiscal cup runneth over? The policy challenge, therefore, is to either find the fiscal space for cash transfers by reducing existing subsidies and welfare programmes, or to offer either existing product subsidies or equivalent cash transfers, but not both. In the current environment, both options look politically daunting.

Could the RBI’s excess capital pay for income support?

  1. RBI special dividend will either be one-off or staggered over a few years, whereas any new farm-income-support creates a perpetual liability.
  2. Second, from an accounting perspective, the fiscal deficit will not widen because the additional expenditure will be paid for by the transfer of capital from the RBI.
  3. If the transfer, for example, is spent on cash transfers — instead of retiring public debt — the “effective fiscal impulse” will increase by the full quantum of that spending tantamount to a fiscal stimulus, with the attendant implications on pressurising macroeconomic imbalances.

Will the pressure on the fiscal be accompanied by monetary and regulatory easing?

  1. There is growing market/bank clamour for some regulatory easing towards banks. Policymakers must eschew this.
  2. NPAs appear to have peaked, the IBC has changed the debtor-lending balance of power, the government has injected more capital, and credit growth has increased smartly in recent months.
  3. Lowering lending standards through any regulatory easing at this stage, risks undoing accruing gains and triggering a fresh wave of NPAs down the line.

Way forward

  1. India cannot get complacent in this environment and inadvertently indulge in any excesses. India’s growth prospects have improved, and there is no case, or space, for an inadvertent confluence of fiscal/regulatory/monetary easing.
  2. Resolving the stress in agriculture and SMEs is imperative but requires well-known supply-side reforms to improve scale, productivity and viability.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

To read about the basic concepts of economics at play here:

  1. Economics | Fiscal Policy Explained
  2. Economics | Monetary Policy Explained with Examples

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

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