RBI rate hike

May 5, 2022
Posted by: OptimizeIAS Team
Category: DPN Topics

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RBI rate hike

Subject: Economy

Section: Monetary Policy

Context:

The RBI’s rate setting panel on Wednesday announced an ‘off-cycle’ increase in benchmark interest rates.

Details:

Rise in Repo Rate– by 40 basis points to 4.4% with immediate effect.
Increase in the cash reserve ratio (CRR) by 50 basis points (bps) from 4 per cent to 4.50 per cent.

Causes:

Russia’s invasion of Ukraine and the subsequent western sanctions on Moscow led to supply chain disruption and cost push inflation.
Indian households’ perception and expectations of inflation have been running well above the RBI’s upper tolerance threshold of 6% for more than two years..
Fed policy normalisation causing capital outflows
Heightening the risks of imported inflation due to new COVID infections
India’s Monetary Policy Framework holds RBI responsible and accountable, should retail inflation overshoot the 6 per cent target for three consecutive quarters.

Impact:

Rise lending rate- as repo rate is linked to lending rate
Rise deposit rate
Reduce liquidity
Eliminate capital outflow
Deachor inflation expectation
Rise in bond yield
Currency appreciation

Issue:

Unsuccessful earlier efforts -despite RBI’s attempts to soak up liquidity through the VRRR and SDF windows, domestic liquidity has remained in the surplus.
Cost Pull Inflation-Present inflation is mainly supply led hence, managing demand side variables might not quickly be transmitted to lower inflation.
Stagflation- actions might hold back recovery without much effective decline in inflation, leading the economy to Stagflation.
Capital outflows- on the backdrop of rising Fed policy rate, capital might continue to leave Indian Territory.
Chances of perverse policy-as change in inflation expectation caused mainly due to changes in price of daily use items thus, reflect a transitory inflation.
Fiscal-monetary conflict– as tightening monetary policy would increase cost of borrowing for government
Crowd out effect of tight monetary policy- as cost of borrowing would rise leading to decline in private consumption and investment.
Output gap is still negative– as output is below full-capacity production due to COVID pandemic.

Alternatives

Selective Credit Control measures by the RBI
Pro-growth measure — a reduction in fuel taxes by both Central and State governments to neutralise the adverse impact of the rise in international crude oil prices on the wake of record collections in the GST.
Supply Chain Diversification and ease supply

RBI Inflation Targeting:

Inflation Targeting is a monetary policy framework wherein the Central Bank of a country focuses only on maintaining the rate of Inflation within a targeted range.

The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation.

Inflation targeting was first adopted by New Zealand and subsequently, a large number of countries including India have been following Inflation Targeting as their core element of monetary policy.

In case of India, the flexible Inflation targeting was introduced through the Monetary Policy Framework Agreement signed between the RBI and Government in 2015. As per terms of the agreement, RBI’s primary objective would be to maintain price stability, while keeping in mind the objective of growth. The RBI is required to maintain a rate of inflation of 4% with a deviation of 2% i.e. inflation has to be maintained between 2% to 6%.

The Reserve Bank of India Act, 1934 was amended to provide a statutory basis for a FTI framework. The amended Act provides for the inflation target to be set by the Government, in consultation with the RBI, once every five years.

Monetary Policy Committee:

It is a statutory and institutionalized framework under the Reserve Bank of India Act, 1934, for maintaining price stability, while keeping in mind the objective of growth.

The Governor of RBI is ex-officio Chairman of the committee. The MPC determines the policy interest rate (repo rate) required to achieve the inflation target (4%).

Traditional measures to control inflation by the RBI

In the Indian Economy, RBI is the sole authority that decides the money supply in the economy. And to control this, RBI implements the monetary policy’s Quantitative and Qualitative instruments to achieve economic goals-

The quantitative instruments are also known as general tools used by the RBI (Reserve Bank of India). As the name suggests, these instruments are related to the quantity and volume of the money. These instruments are designed to control the total volume/money of the bank credit in the economy.
- Bank rate is the minimum rate at which the central bank lends money and rediscounts first-class bills of exchange and securities held by commercial banks.
- Legal Ratio-To maintain liquidity and to control credit in the economy, the RBI also keeps a certain amount of cash reserves. These reserve ratios are known as SLR (Statutory Liquidity Ratio) and CRR (Cash Reserve Ratio), increase in both of these ratios lead to decline in inflation.
- Liquidity Adjustment Facility-It is a monetary policy tool used largely by the Reserve Bank of India (RBI) that controls the liquidity of money supply in the economy. It is done by either allowing banks to borrow money via repurchase agreements (repos) or lend loans to the RBI via reverse repo agreements. There are two main components of Liquidity Adjustment Facility (LAF):
  - Repo Rate: It is the rate at which the Reserve Bank of India (RBI) lends to other banks.
  - Reverse Repo Rate: It is the rate at which the Reserve Bank of India (RBI) borrows from commercial banks.It is conducted at a fixed and variable rate.
- The Marginal Standing Facility (MSF)- refers to the facility under which scheduled commercial banks can borrow an additional amount of overnight money from the central bank over and above what is available to them through the LAF The MSF rate is pegged 100 basis points or a percentage point above the repo rate.
- Standing Deposit Facility (SDF) –It is an additional tool for absorbing liquidity. It is the same as reverse without any collateral. It will replace the fixed rate reverse repo (FRRR) as the floor of the LAF corridor.

Qualitative instruments are also known as selective instruments of the RBI’s monetary policy. These instruments are used for discriminating between various uses of credit; for example, they can be used for favouring export over import or essential over non-essential credit supply.
- RBI fixes a credit amount to be granted for commercial banks. Credit is given by limiting the amount available for each commercial bank. For certain purposes, the upper credit limit can be fixed, and banks have to stick to that limit. This helps in lowering the bank’s credit exposure to unwanted sectors.
- Regulation of consumers’ credit-consumers’ credit supply is regulated through the instalment of sale and hire purchase of consumer goods
- Change in Marginal Requirement-Margin is referred to the certain proportion of the loan amount that is not offered or financed by the bank. Change in margin can lead to change in the loan size. This instrument is used to encourage the credit supply for the necessary sectors and avoid it for the unnecessary sectors. That can be done by increasing the marginal of unnecessary sectors and reducing the marginal of other needy sectors.
- Moral suasion refers to the suggestions to commercial banks from the RBI that helps in restraining credits in the inflationary period. RBI implies pressure on the Indian banking system without taking any strict action for compliance with rules.

Instruments	Rise-(instrument)	Fall-(instrument)
Instruments	Liquidity and inflation
Bank rate	falls	rises
SLR (Statutory Liquidity Ratio)	falls	rises
CRR (Cash Reserve Ratio)	falls	rises
Repo Rate	falls	rises
Reverse Repo Rate	falls	rises
The Marginal Standing Facility (MSF)	falls	rises
Standing Deposit Facility (SDF)	falls	rises