Monetary Policy Explained

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Context:
Monetary Policy Committee (MPC) of the Reserve Bank of India, headed by Governor Shaktikanta Das, has decided to keep the policy rates unchanged for the third time in a row in the bi-monthly monetary policy announced on December 4.

Relevance:
Mains: GS III-

  • Indian Economy & issues relating to planning, mobilization of resources, growth, development & employment.
Introduction

Monetary policy refers to the use of monetary instruments under the control of the central bank to regulate magnitudes such as interest rates, money supply, and availability of credit to achieve the ultimate objective of economic policy.

The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy. This responsibility is explicitly mandated under the Reserve Bank of India Act, 1934.

The goals of monetary policy:

  • The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth.
  • Price stability is a necessary precondition to sustainable growth.
Inflation-targeting framework
  • In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation-targeting framework.
  • The amended RBI Act also provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once every five years.
  • Accordingly, the Central Government has set a target Consumer Price Index (CPI) inflation rate of 4 percent with a band of +/- 2 percent for the period from August 5, 2016, to March 31, 2021.
  • The Central Government notified the following as factors that constitute a failure to achieve the inflation target:
    • The average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters,
    • The average inflation is less than the lower tolerance level for any three consecutive quarters.
Monetary Policy Framework
  • The amended RBI Act explicitly provides the legislative mandate to the Reserve Bank to operate the monetary policy framework of the country.
  • This framework aims to set the policy (repo) rate after the assessment of the current and evolving macroeconomic situation, and modulation of liquidity conditions to anchor money market rates at or around the repo rate.
  • Repo rate changes transmit through the money market to the entire financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth.
  • The policy decisions are announced by the Reserve Bank of India (RBI) governor at the bi-monthly monetary policy.
  • RBI policy stance:
    • Neutral stance: RBI will alter rates in any direction to control the money supply in the system.
    • Accommodative stance: RBI will cut rates to inject money into the financial system whenever needed.
    • Calibrated tightening: This means that in the current rate cycle, a cut in the policy repo rate is off the table, and RBI is not obliged to increase the rate at every policy meeting.
Monetary policy committee (MPC)
  • Section 45ZB of the amended RBI Act, 1934 provides for an empowered six-member monetary policy committee (MPC) to be constituted by the Central Government
  • MPC will bring more transparency and accountability in fixing India's Monetary Policy.
  • Structure and composition of MPC:
    • The committee comprises six members – three officials of the Reserve Bank of India 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 (specifically, at least once every quarter) and it publishes its decisions after each such meeting.
    • The quorum for the meeting of the MPC is four members.
    • The monetary 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 quarters.
    • The Governor of the Reserve Bank of India is the chairperson ex officio of the committee.
    • Decisions are taken by the majority with the Governor having the casting vote in case of a tie. 
  • The mandate of MPC: 
    • The Monetary Policy Committee is responsible for fixing the benchmark interest rate in India.
    • To ensure inflation stayed in the 2-6% range over the next five years, with the target set at the midpoint, 4%.
    • MPC would also take into account growth concerns while setting policy rates. 
  • Arguments in favor of MPC:
    • Some economists see the MPC as a rare reform that has achieved its key goal of low inflation.
    • The inflation-targeting regime also contributed to the success in taming price rise.
    • MPC was successful in controlling the demand-pull inflation.
    • Maintaining stable and moderate inflation is good for the economy.
  • Arguments against MPC:
    • By focusing narrowly on curbing inflation, the MPC lost sight of growth, contributing to India’s economic slowdown.
    • Concern regarding the availability of high-quality data to MPC members.
    • Tight monetary policy might lead to a slowdown in the economy.
    • Expansionary monetary policy might lead to hyperinflation.
Process of Monetary policy formulation
  • Monetary policy is formulated based on inputs gathered from a variety of sources.
  • For instance, the monetary authority may look at macroeconomic numbers such as gross domestic product (GDP) and inflation, industry/sector-specific growth rates and associated figures, as well as geopolitical developments in international markets—including oil embargos or trade tariffs.
  • These entities may also ponder concerns raised by groups representing industries and businesses, survey results from organizations of repute, and inputs from the government and other credible sources.
  • Monetary Policy Committee (MPC) 
    • Determines the policy interest rate required to achieve the inflation target.
  • Reserve Bank’s Monetary Policy Department (MPD) 
    • Assists the MPC in formulating the monetary policy.
    • Views of key stakeholders in the economy and analytical work of the Reserve Bank contribute to the process for deciding on the policy repo rate.
  • Financial Markets Operations Department (FMOD)
    • Operationalises the monetary policy, mainly through day-to-day liquidity management operations. 
  • Financial Market Committee (FMC):
    • Meets daily to review the liquidity conditions to ensure that the operating target of monetary policy (weighted average lending rate) is kept close to the policy repo rate.

Significance of monetary policy
  • Manage inflation: Most important objective of monetary policy. In general, low inflation is most conducive to a healthy, thriving economy. Therefore, when inflation is on the rise, the Central bank may adjust monetary policy to reduce inflation.
  • Reduce unemployment: Increase in the money supply helps to stimulate the business sector, which also helps to create more jobs
  • Balance currency exchange rates: Central banks have the power to regulate exchange rates between foreign and domestic currencies. For instance, if the central bank opts to issue more currency to increase the money supply, domestic currencies become cheaper than foreign currencies.
  • Monetary policy shapes variables like Consumption, Savings, Investment, and capital formation.
  • It plays an important role in price stability and economic growth.
  • It deals with the demand side of economic policy and thus influencing demand-pull inflation.
Types of monetary policy
  1. Expansionary monetary policy:
    • The purpose of this type of monetary policy is to increase the money supply within the economy by completing actions such as
      • decreasing interest rates,
      • lowering reserve requirements for banks and
      • purchasing government securities by central banks.
    • This type of monetary policy helps to lower unemployment rates as well as stimulate business activities and consumer spending.
    • The overall goal of this policy is to fuel economic growth.
    • Nevertheless, it can also have an adverse effect, occasionally leading to hyperinflation. 
  2. Contractionary monetary policy:
    • This type of policy is used to decrease the amount of money circulating throughout the economy.
    • It is most often achieved by actions such as
      • selling government bonds,
      • raising interest rates and
      • increasing the reserve requirements for banks.
    • This method is used when the government wants to avoid inflation.
Tools of monetary policy
  • Quantitative/ Indirect tools:
    • Repo rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF). It is determined by the Monetary Policy Committee.
    • Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF.
    • Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow an additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system.
    • Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes.
    • Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with the Reserve Bank as a share of such percentage of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of India.
    • Statutory liquidity ratio: The share of NDTL that a bank is required to maintain in safe and liquid assets, such as unencumbered government securities, cash, and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.
    • Open market operations (OMOs): Conducted by the Reserve Bank of India (RBI) by way of sale and purchase of government securities in the open market to regulate the supply of money.
    • Market Stabilisation Scheme (MSS): Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through the sale of short-dated government securities and treasury bills.
  • Qualitative/ Direct tools:
    • Moral Suasion: Refers to a method adopted by the central bank to persuade or convince the commercial banks to advance credit following the directives of the central bank in the economic interest of the country.
    • Margin requirement: Refers to the difference between the current value of the security offered for the loan (called collateral) and the value of the loan granted. It is a qualitative method of credit control adopted by the central bank to stabilize the economy from inflation or deflation.
    • Selective credit control: Refers to the qualitative method of credit control by the central bank. The method aims, unlike general or quantitative methods, at the regulation of credit taken for specific purposes or branches of economic activity.
    • Priority Sector Lending: It is an important role given by the (RBI) to the banks for providing a specified portion of the bank lending to few specific sectors like agriculture and allied activities, micro and small enterprises, poor people for housing, etc.
Difference between monetary policy and fiscal policy

The differences between monetary policy and fiscal policy are:

Monetary policy Fiscal policy
Determined by the central bank Determined by government legislation
Addresses interest rates and the supply of money in circulation Addresses taxation and government spending
Inflation-targeting is followed in India No specific target
Influences currency exchange rates, consumption, and savings. Influences the government budget.
Mostly independent of the political process Politics has a strong influence on deciding the tax rate

Monetary policy can be used in combination with or as an alternative to fiscal policy, which uses taxes, government borrowing, and spending to manage the economy.

Recent RBI Monetary Policy Highlights
  • Reserve Bank of India (RBI) in its sixth bi-monthly monetary policy committee (MPC) meeting voted unanimously to maintain the repo rate at 4% and the reverse repo rate at 3.35%.
  • The six-member MPC voted unanimously to keep the stance accommodative to facilitate the recovery in the economic indicators. 
  • Speaking about payments and settlement system, the RBI governor said that RTGS will be made 24X7 in the next few days.
  • Speaking about the GDP growth, the RBI governor said that the central bank now projects the real GDP growth for FY21 at -7.5% from the -9.5%it projected in their earlier meeting.
  • The reasons for the accommodative stance are:
    • To revive growth on a durable basis
    • To support increasing demand.
      • Green-shoots of recovery were too reliant on rural demand with urban demand yet to follow suit.
      • Hence an accommodative policy and low rates would be essential till the time urban demand also picked up.
    • Mitigate the impact of Covid-19 while ensuring that inflation remains within the target.
    • There is the hope of containment of the corona pandemic through the vaccines.
    • Global central banks are continuing an accommodative stance.
      • At their latest policy meetings, the US Federal Reserve, the European Central Bank, and the Bank of Japan, among others, remain committed to supporting economic growth via monetary policy expansions

Thus the vaccination optimism and continued bullish sentiment made MPC take an accommodative stance.

Limitations of monetary policy in India
  • There are several interest rates in our economy, and the policy repo rate alone is insufficient to influence them all appropriately.
  • Unfavourable Banking Habits:
    • An important limitation of the monetary policy is the unfavourable banking habits of the Indian masses.
    • People in India prefer to make use of cash rather than cheque.
    • This means that a major portion of the cash generally continues to circulate in the economy without returning to the banks in the form of deposits.
    • This reduces the credit creation capacity of the banks.
  • Underdeveloped Money Market:
    • The weak money market limits the coverage, as also the efficient working of the monetary policy.
    • The money market comprises of the parts, the organized money market, and the unorganized money market.
    • The money policy works only in an organized money market.
    • It fails to achieve the desired results in an unorganized money market.
  • Existence of Black Money:
    • The existence of black money in the economy limits the working of the monetary policy.
    • The black money is not recorded since the borrowers and lenders keep their transactions secret.
    • Consequently, the supply and demand of the money also do not remain as desired by the monetary policy. 
  • Conflicting Objectives:
    • To achieve the objective of economic development the monetary policy is to be expansionary.
    • Contrary to it to achieve the objective of price stability a curb on inflation can be realized by contracting the money supply.
    • The monetary policy generally fails to achieve proper coordination between these two objectives.
  • Influence of Non-Monetary Factors:
    • An important limitation of monetary policy is its ignorance of non-monetary factors.
    • The monetary policy can never be the primary factor in controlling inflation originating in real factors, deficit financing, and foreign exchange resources.
    • The Reserve Bank has no control over deficit financing.
    • It cannot regulate deficit financing, which affects the money supply considerably.
  • Limitations of Monetary Instruments:
    • An important limitation of monetary policy is related to the inherent limitations in the various instruments of credit control.
    • There are limitations regarding frequent and sharp changes in the bank rate, as these are supposed to conflict with the development objectives.
    • Most bank rates are virtually fixed and mutually unrelated so that the scope for adjustment is very limited.
    • The margin requirements have tended to be so high for most of the time due to prolonged inflation, that the scope for further increase in them is limited.
    • The CRR and SLR have also been fixed very high locking most of the funds in low yielding assets.
    • These limitations of monetary instruments hamper the smooth working of monetary policy.
Conclusion and way forward
  • Through covid-19, the Reserve Bank of India (RBI) and the Monetary Policy Committee (MPC) have had to undertake a series of extraordinary steps.
  • These include deep policy interest rate cuts, strong banking liquidity infusion, intense bond, and currency market operations, besides measures to preserve financial stability.
  • However, the simplistic framework of inflation targeting has many limitations.
  • While the MPC and RBI outwardly continue their inflation-targeting as required by law, we will finally need the right mix of policy rates, banking liquidity, RBI operations in bond and currency markets, capital flow measures, fiscal policies, and macroprudential regulations.
  • The International Monetary Fund’s Gita Gopinath had earlier made a similar case for an integrated policy framework.



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