Reserve Bank of India (RBI) is scheduled to do its next bi-monthly monetary policy review on 29th of September 2015. The Governor of RBI, Raghuram Rajan, is under pressure from both Government and the industry, to loosen monetary policy.
Monetary policy is the action taken by the central bank/ RBI to control the amount of money supply. RBI has several monetary policy tools which it uses to influence money supply in the economy. They are Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), repo rate etc. (explained at the end).
A central bank usually seeks to achieve two major objectives with its monetary policy: high Growth and low Inflation and both cannot be achieved together. There is a trade-off between growth and inflation
To illustrate, if there is high inflation in the economy, central bank reduces money supply in the economy to reduce inflation.
Money Supply ↓ ⇒ demand for goods and services ↓ ⇒ price ↓ ⇒ inflation rate ↓
But, this reduced money supply impacts investment and consumer demand and thereby hampers the growth in the economy. One objective is achieved at the expense of other and the central bank has to strike a balance between both these objectives.
After the Urjit Patel Committee report, RBI explicitly set “inflation based on consumer price index (CPI)” as its main objective. (Read this article to know more about CPI.) It decided to use monetary policy tools to keep CPI inflation rate within the range of 2 to 6%. Previously, it had multiple objectives like inflation, growth, employment, exchange rate etc.
In the next monetary policy review, Government and industry want RBI to loosen/ increase the money supply in the economy. This is because the growth rate of India has slowed down even when inflation has moderated. Inflation based on Wholesale Price Index has been negative for 8 consecutive months. CPI inflation rate also reduced to 3.6% last month (August 2015). And it is within the 2 to 6 % target range set by the RBI.
But, Raghuram Rajan asserts that low inflation is due to the favourable base effect. Inflation was abnormally high in the month of September last year and hence it has become low this year due to favourable base effect. Rajan is of the opinion that if the base effect is taken out, CPI inflation will be around 5.5%. (Read more about the base effect in this article from Investopedia).
On the other hand, there have been warnings that India could be entering a deflationary spiral. ASSOCHAM chairperson Rana Kapoor said, ” Deflation is a far greater worry than inflation considering that some fall in prices could very well result in slowing down of demand in the economy as when prices start falling, a vicious cycle of lower spending and lower demand sets in, thereby hampering growth.”
There is clearly a difference of opinion on the issue and the speculation regarding the monetary policy will be put to rest only by Raghuram Rajan on Tuesday when the policy review is scheduled to take place.
Let us discuss the monetary policy tools used by the RBI to achieve its objectives:
MONETARY POLICY TOOLS OF THE CENTRAL BANK
- Statutory liquidity Ratio: It is the percentage of deposits that a bank has to invest in cash, gold or Government securities. When Government increases SLR, the bank has to keep a larger percentage of its deposits in cash, gold and Government securities. It cannot lend this amount to consumers and businesses. Hence, the money supply decreases. (SLR ↑ ⇒ money supply ↓). This rate is currently 21.5% of deposits with the bank.
- Cash reserves Ratio (CRR): It is the percentage of deposits that a bank has to keep as reserves with the RBI. When Government increases CRR, the bank has to keep a larger percentage of its deposits as reserves. It has lesser funds available to lend. Its capacity to lend decreases. Hence, money supply also decreases. (CRR ↑ ⇒ money supply ↓). This rate is currently 4%.
- Open Market operations (OMO): RBI buys and sells Government securities in the open market to maintain the money supply in the economy. If it has to reduce the money supply, it will start selling Government securities in the open market and vice versa. This is called Open Market Operations (OMO). (Sell securities ⇒ money supply ↓).
- Bank rate: Bank rate is the rate at which RBI lends funds to the commercial banks. If this rate increases, it becomes expensive to borrow from the RBI. Therefore, banks increase its lending rates. Hence, lending activities decline. (Bank rate ↑ ⇒ money supply ↓) This rate is currently 7.75%.
- Repo rate: Repo rate is the rate at which RBI lends funds to the banks against securities. To illustrate, if a bank wants to borrow money from RBI, it will have to keep Government securities as collateral. It will also have to promise the RBI that it will repurchase these securities at a higher rate at some time in the future. An increase in repo rate will lead to similar effects as the increase in Bank rate. (Repo rate ↑ ⇒ money supply ↓). This rate is currently 6.75 %.
- Reverse repo rate: Reverse repo is the rate at which banks keep their excess funds with the RBI. If reverse-repo rate increases, banks will find it profitable to keep its funds with RBI. Hence, lending activities will decline (Reverse repo rate ↑ ⇒ money supply ↓). The Reverse repo rate is always 1% less than the repo rate. It is 5.75 % at present.
These are the monetary policy tools used by Central bank. We will find out what RBI chooses to do with these rates on 29th of this month.
For further readings, you can check out the following article on our blog:
Monetary Policy Committee Explained
RBI’s changes in the calculation of base rate: explained
Gold Monetisation and Sovereign Gold Bond Scheme: Demystified