monetary-normalisation

Context: The Monetary Policy Committee of the Reserve Bank of India maintained status quo in the policy rates as also in the policy stance in its fourth bi-monthly meeting this fiscal. 

Key points

  • There was agreement on the part of all members to hold the repo and reverse repo rates unchanged at 4 per cent and 3.35 per cent.
    • Repo rate is the rate at which the Central Bank grants loans to commercial banks against government securities. Reverse repo rate is the interest offered by RBI to banks who deposit funds with them.
    • The purpose of keeping an asymmetric gap between the reverse repo rate and repo rate is to make it relatively unattractive for banks to passively deposit funds with the RBI and instead, to use these funds for lending to productive sectors of the economy.
  • There were expectations that the RBI would go for normalisation of the extra-loose monetary and liquidity policies being pursued since the onset of the pandemic in March last year. 
    • Monetary policy normalisation means monetary tightening. 
    • Normalisation means removal of excess liquidity that was injected by the RBI with a view to supporting ‘a speedy and durable economic recovery’. 

Concerns with excess liquidity in market:

  • The surplus liquidity in the banking system witnessed a three-fold increase from a daily average of ₹3 lakh crore in March, 2020 to ₹9 lakh crore in September, 2021 and further to ₹9.5 lakh crore in the first few days of October. 
    • As per the estimation made by the RBI in this regard, the extra liquidity amounts to more than ₹13.0 lakh crore — about 25 per cent of the country’s GDP.
  • Higher inflation: The risk of delaying normalisation for too long would be the prospects of higher inflation. A view was expressed by a member of the MPC that monetary accommodation appears to be stimulating asset price inflation to a greater extent than it is mitigating the distress in the economy.

RBI’s dilemma

  • One, at this stage of the Covid-19 pandemic, whether continuation of extra-loose monetary and liquidity policies would result in more macroeconomic benefits than costs.
  • Two, given the fact that the actual CPI inflation at above 5 per cent has been consistently exceeding the 4 per cent target, will the MPC not be diluting its mandate by prioritising growth over inflation? 
  • The country’s GDP is still below the pre-pandemic level and, hence, there is significant slack in resource utilisation in the economy which needs to be reduced expeditiously to spur growth. 
    • Ample liquidity infusion and significant interventions in the forex and G-Sec markets are necessary to ensure not only their orderly functioning but also to guide price discovery in them. 
  • The dominant view appears to interpret the MPC’s (4 +/-2) per cent inflation targeting framework to mean that in the current exceptional and pandemic-ravaged time, the effective target should be 6 per cent and not 4 per cent. 
  • There seems to be a lack of clarity on the precise meaning and implications of the +/-2 per cent band around 4 per cent.

Way forward:

  • First, RBI should stop the G-Sec Acquisition Programme (G-SAP) for the present.  G-SAP is basically an unconditional and a structured Open Market Operation (OMO), of a much larger scale and size. It infuses heavy liquidity in the market.
    • Open Market Operations (OMOs) are market operations conducted by RBI by way of sale/purchase of government securities to/from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.
  • The RBI may consider complementing the 14-day variable rate reverse repo (VRRR) auctions, which is currently its main instrument for liquidity absorption with 28-day VRRR auctions in a calibrated fashion.
    • In order to absorb additional liquidity in the system, the RBI conducted a Variable Rate Reverse Repo (VRRR) program due to the higher yield prospects as compared to the fixed rate overnight reverse repo.
  • Phased removal of excess liquidity would lead to money market rates rising above the reverse repo rate of 3.35 per cent which would eventually allow the RBI to narrow the gap between repo and reverse repo rates from the present high of 65 basis points. 
    • This gap, which was 25 basis points in the pre-pandemic era, was expanded in phases, beginning with the policy announcement on March 27, 2020.  

The liquidity conditions emanating from the exceptional measures instituted during the crisis would need to evolve in sync with the macroeconomic developments to preserve financial stability. This process has to be gradual, calibrated and non-disruptive, while remaining supportive of the economic recovery.

Monetary policy

Types of Monetary Policy

Broadly, there are two types of monetary policy,

  • Expansionary Monetary Policy
  • Contractionary Monetary Policy

Expansionary Monetary Policy

Expansionary monetary policy increases the money supply in order to lower unemployment, boost private-sector borrowing and consumer spending, and stimulate economic growth. Often referred to as "easy monetary policy". This description applies to many central banks since the 2008 financial crisis, as interest rates have been low and in many cases near zero.  

Contractionary Monetary Policy

Contractionary monetary policy slows the rate of growth in the money supply or outright decreases the money supply in order to control inflation. While sometimes necessary, contractionary monetary policy can slow economic growth, increase unemployment and depress borrowing and spending by consumers and businesses.

The 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.
  • Target given to MPC: The Reserve Bank of India’s (RBI) MPC was given the target of keeping inflation at 4% +/- 2%. This meant that inflation should be between 2% and 6%. 

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