ROLE OF RBI IN CONTROLLING INFLATION

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Context

• The repo rate is the fixed interest rate at which RBI provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
• The repo rate system allows central banks to control the money supply within economies by increasing or decreasing the availability of funds.(i.e controlling inflation)

 

What is Inflation?

• Inflation refers to a sustained increase in the general price level of goods and services in an economy over a period of time.
• It is the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc.
• Inflation measures the average price change in a basket of commodities and services over time.
• The opposite and rare fall in the price index of this basket of items is called ‘deflation’.
• Inflation is indicative of the decrease in the purchasing power of a unit of a country’s currency. This is measured in percentage.

 

Measures to control Inflation

• Inflation is caused by the failure of aggregate supply to equal the increase in aggregate demand. Inflation can, therefore, be controlled by increasing the supplies of goods and services and reducing money incomes in order to control aggregate demand.
• Some of the important measures to control inflation are as follows:

 

 

Role of RBI in controlling Inflation: Using Monetary Policy

Monetary policy

• It is the macroeconomic policylaid down by the central bank-RBI.
• Monetary policy is a set of tools that a nation's central bank has available to promote sustainable economic growth by controlling the interest rate and the overall supply of money that is available to the nation's banks, its consumers, and its businesses.
• It is the demand side economic policy that is used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.
• In India, monetary policy of the Reserve Bank of India is aimed at managing the quantity of money in order to meet the requirements of different sectors of the economy and to increase the pace of economic growth.
• The RBI implements the monetary policy through open market operations, bank rate policy, reserve system, credit control policy, moral persuasion and through many other instruments.
• Using any of these instruments will lead to changes in the interest rate, or the money supply in the economy.

Monetary Policy Tools

• To control inflation, the Reserve Bank of India needs to decrease the supply of money or increase cost of fund in order to keep the demand of goods and services in control.
• RBI Monetary Policy instruments are divided into two category qualitative instruments and quantitative instruments.

 

QUANTITATIVE TOOLS

The tools applied by the policy that impact money supply in the entire economy, including sectors such as manufacturing, agriculture, automobile, housing, etc.

 

1. Reserve Rate [CRR AND SLR]

• Banks are required to keep aside a set percentage of cash reserves or RBI approved assets. Reserve ratio is of two types:
• Cash Reserve Ratio (CRR) – Banks are required to set aside this portion in cash with the RBI. The bank can neither lend it to anyone nor can it earn any interest rate or profit on CRR.

 

• Statutory Liquidity Ratio (SLR) – Banks are required to set aside this portion in liquid assets such as gold or RBI approved securities such as government securities. Banks are allowed to earn interest on these securities, however it is very low.

 

2. Open Market Operations (OMO):

• In order to control money supply, the RBI buys and sells government securities in the open market. These operations conducted by the Central Bank in the open market are referred to as Open Market Operations.
• When the RBI sells government securities, the liquidity is sucked from the market, and the exact opposite happens when RBI buys securities. The latter is done to control inflation. The objective of OMOs is to keep a check on temporary liquidity mismatches in the market, owing to foreign capital flow.

 

3.      Market Stabilization Scheme (MSS)

[Policy Rates]

1. Bank rate – The interest rate at which RBI lends long term funds to banks is referred to as the bank rate. However, presently RBI does not entirely control money supply via the bank rate. It uses Liquidity Adjustment Facility (LAF) – repo rateas one of the significant tools to establish control over money supply.

Bank rate is used to prescribe penalty to the bank if it does not maintain the prescribed SLR or CRR.

1. Liquidity Adjustment Facility (LAF) – RBI uses LAF as an instrument to adjust liquidity and money supply. The following types of LAF are:
2. Repo rate:Repo rate is the rate at which banks borrow from RBI on a short-term basis against a repurchase agreement. Under this policy, banks are required to provide government securities as collateral and later buy them back after a pre-defined time.

 

Decoding Repo Rate 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 State Bank of India 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? 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, in large measure, 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 that in turn push up the costs of inputs used by producers of goods and providers of services, 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 by making 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.   What other factors influence the repo rate’s efficacy? Repo rate increases impact the real economy with a lag. In February 2021, the RBI in its annual ‘Report on Currency and Finance’ observed that “the challenge of monetary policy is to minimize the transmission lag from changes in the policy rate to the operating target”, which in this case is the mandate to keep medium-term inflation anchored at 4%, and bound within a tolerance range of 2% to 6%. [The transmission lag is the time interval between the policy decision and the subsequent change in policy instruments. This is also a more serious obstacle for fiscal policy than for monetary policy. For frequent changes in bank rate there is no transmission lag in case of monetary policy] The RBI noted in the report that there were several channels of transmission, (a)    ‘the interest rate channel; (b)    the credit or bank lending channel; (c)     the exchange rate channel operating through relative prices of tradables and non-tradables; (d)    the asset price channel impacting wealth/income accruing from holdings of financial assets; and (e)    the expectations channel encapsulating the perceptions of households and businesses on the state of the economy and its outlook’. These conduits of transmission intertwine and operate in conjunction and are difficult to disentangle. These are the challenges monetary authorities face in ensuring that changes to the repo rate actually help in achieving the policy objective.

 

1. Reverse Repo rate:It is the reverse of repo rate, i.e., this is the rate RBI pays to banks in order to keep additional funds in RBI. It is linked to repo rate in the following way:

    Reverse Repo Rate = Repo Rate – 1

• Marginal Standing Facility (MSF) Rate:MSF Rate is the penal rate at which the Central Bank lends money to banks, over the rate available under the rep policy. Banks availing MSF Rate can use a maximum of 1% of SLR securities.

    MSF Rate = Repo Rate + 1

 

QUALITATIVE TOOLS

Unlike quantitative tools which have a direct effect on the entire economy’s money supply, qualitative tools are selective tools that have an effect in the money supply of a specific sector of the economy.

1. Margin requirements – The RBI prescribes a certain margin against collateral, which in turn impacts the borrowing habit of customers. When the margin requirements are raised by the RBI, customers will be able to borrow less.
2. Moral suasion – By way of persuasion, the RBI convinces banks to keep money in government securities, rather than certain sectors.
3. Selective credit control – Controlling credit by not lending to selective industries or speculative businesses.

 

Monetary Policy Committee

• About: MPC is a government-constituted body of the RBI, which is responsible for framing the monetary policy of the country, using the tools like repo rate, reverse repo rate, bank rates etc.
• Proposal: Urjit Patel Committee was the first committee who proposed the Monetary Policy Committee (MPC).The first meeting of MPC was conducted on 3rd October 2016 in Mumbai.
• Mandate: Prime objective of RBI MPC is to determine the policy interest rate required to achieve the inflation target.
• Act: RBI Act, 1934 empowers the RBI to take Monetary Policy Decisions.
• Meetings: The meetings of the Monetary Policy Committee are held at least 4 times a year(specifically, at least once BIMONTHLY) and it publishes its decisions after each such meeting.
• Composition: The committee comprises six members - three officials of the Reserve Bank of India and three external members nominated by the Government of India.

The Governor of Reserve Bank of India is the chairperson ex officio of the committee.

• Term: each member has tenure of four years.
• Confidentiality: They need to observe a "silent period" seven days before and after the rate decision for "utmost confidentiality".
• Decision: Decisions are taken by majority with the Governor having the casting vote in case of a tie. MPC decisions are taken by voting, where a simple majority (4 out of 6) is necessary for a decision to be passed.
• Inflation targets:

Targeted consumer price index (CPI) inflation rate is= 4%

Upper tolerance limit of inflation is = Target inflation rate + 2% = (4% + 2%) =6%

Lower tolerance limit of inflation is = Target inflation rate – 2% = (4% – 2%) =2%

Targeted consumer price index (CPI) inflation rate period from = April 1, 2021

Targeted consumer price index (CPI) inflation rate period up to = March 31, 2026

 

THE RECENT SUDDEN RISE IN REPO RATE AND CRR

• The revised repo rate now stands at 4.40 percent and the CRR at 4.5 percent.

Why has the RBI increased the repo rate?

• RBI has increased the repo rate due to rising inflation, geopolitical tensions, high crude oil prices, and shortage of commodities globally, which have impacted the Indian economy.
• Monetary policy action is aimed at containing inflation spike and re-anchoring inflation expectation. High inflation is known as detrimental to growth.

 

Impact

[Stock market]

• An increase in interest rates means an increase in savings and a reduction in the flow of capital to the economy, which results in slump in stock markets.
• The stock market and the interest rates have an inverse relationship. Every time the central bank increases the repo rate, it prompts companies to also cut back on the spending on the expansion, which leads to a dip in growth and affects the profit and future cash flows, resulting in a fall in stock prices.

[Loan and EMI Rates]

• The increase in repo rate will push banks and non-banking financial companies (NBFCs) to hike lending and deposit rates.
• This means the interest rates on loans will go up. Equated monthly installments (EMIs) on home, vehicle and other personal and corporate loans are likely to rise.

[Unequal impact]

• Capital-intensive sectors such as capital goods, infrastructure, etc, are more vulnerable to these changes due to high capital or debt on the books of these companies.
• While stocks of sectors like Information Technology (IT) or Fast-moving consumer goods (FMCG) usually see a lesser impact.

 

[Inflation]

• During high levels of inflation, RBI makes strong attempts to bring down the flow of money in the economy.
• One way to do this is by increasing the repo rate. This makes borrowing a costly affair for businesses and industries, which in turn slows down investment and money supply in the market.
• As a result, it negatively impacts the growth of the economy, which helps in controlling inflation.

 

Must Read: https://www.iasgyan.in/daily-current-affairs/inflation-29

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