Reserve Bank's Monetary Policy

Before we dwell on RBI’s Monetary policy let us understand the difference between Monetary and Fiscal policies.

Monetary policy of a country is regulated by its Central Bank, which in our case is Reserve Bank of India (RBI). Function of monetary policy is to regulate money supply in the eco system which helps in controlling inflation and regulation of interest rates. The crux of monetary policy is to balance growth with moderate inflation.

Fiscal policy is the aggregate of measures undertaken by a country’s Government for revenue generation  ie taxation and revenue expenditure. This comes as a part of what is known as Union Budget.  

Here we shall be discussing various parameters of RBI’s monetary policy, as well as the latest policy measures announced on 5^th April 2016. RBI uses various tools to regulate the economy and achieve goals of its monetary policy. Chief amongst them are Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Bank rate, Repo rate/ reverse repo rate etc.

Banks cannot lend all the deposits they receive, but have to keep aside a certain portion of these deposits as reserves. These are mainly CRR, presently 4 % of Bank’s demand and time liabilities -DTL (ie. deposits) and SLR which is currently 21.25 % of DTL. These reserve percentages can be varied ie increased or decreased by RBI for regulating the availability of lendable funds in the eco system. More money chasing fewer goods shall result in increase in prices of goods, thus stoking inflation and vice versa money supply is controlled to keep inflation in check.

Secondly, the funds availability is also regulated by increasing or decreasing its cost. If loans from Banks are costlier, then fewer people will avail of loans. Conversely, if Bank loans become cheaper then more people will take loans, whether for housing or vehicle loans or for trading or for manufacturing projects.

RBI regulates pricing of funds through mechanism of Bank rate  and repo /reverse repo rates.  Repo rate, is the rate at which RBI lends money to Banks, generally against Government securities  and reverse repo rate is the rate at which it accepts money from Banks. Currently Bank rate is 7 %, repo rate is 6 % and reverse Repo rate is 6.50 %. Any increase or decrease in Bank rate and Repo / reverse Repo rates increases or decreases cost of funds of Commercial Banks (CBs) who may be borrowing from RBI. In turn, it affects CB’s own pricing of  funds lent out to borrowers. Cheaper interest rates fuel demand for funds and vice versa. So RBI uses this tool to regulate demand and supply of money in the country’s eco system.

It may be pertinent to point out here that Banks peg their lending rates to a benchmark rate which is known as Base rate. From 1^st April 2016, this has been replaced by a new benchmark to be known as Marginal Cost of funds based Lending rate (MCLR). This has been done to improve transparency about the methodology adopted by Banks’ to fix these benchmark rates. Every Bank has their own Base rate or MCLR, which is computed depending on that Bank’s cost of funds (including deposits / market borrowings etc).

Till the year 2013-14,  RBI used to review the monetary policy at quarterly intervals. From April 2014 onwards, the periodicity of such review has been reduced to bi-monthly, to keep the policy declarations more dynamic and real-time.

For the current fiscal 2016-17, RBI announced its First Bi-Monthly Monetary Policy on 5^th April 2016. It has maintained its positive policy stance forecasting economic growth at 7.6% and Consumer Price Index (CPI) linked inflation at around 5% for this year. The Central Bank has recognized Government’s commitment to lowering fiscal deficit to 3.5% of GDP for this fiscal year (as presented in the Union Budget) and believes that inflation will be stable despite some risks such as impact of recent unseasonal rains, dynamics of monsoon during this fiscal, global commodity prices, implementation of the Seventh Central Pay Commission’s award and One-rank-one pension (OROP) scheme for the defence services.

While reviewing the economic outlook and prospects, RBI Governor Dr Raghuram Rajan announced several policy measures , which can be summarized as under - 

·       Cut in repo rates by 25 basis points (One basis point ie. bps is one hundredth of a percentage point) from 6.75 % to 6.50 %, 

·        Hike in reverse repo rate from 5.75 % to 6 %

·        Net effect of above two measures is that difference between Repo and Reverse repo rates has been reduced from +/-100 bps to +/- 50 bps ,

·        Cash Reserve Ratio (CRR) was kept unchanged at 4.0% of DTL,

·        Minimum daily maintenance of the CRR was reduced from 95% to 90 %, releasing more money to CBs.

In line with the previously announced roadmap, the Statutory Liquidity Ratio (SLR) has already been reduced by 25 bps to 21.25% of bank’s DTL, effective from April 02, 2016. 

RBI Governor also expressed the hope that introduction of MCLR wef 1st April 2016, may by itself lead to a reduction in benchmark rates. So combined with reduction of 25 bps in repo rate, effective reduction in the system may be more than 25 bps. Sounding a positive note, the RBI Governor further expressed hope that aided by a good monsoon, which may lead to a further reduction in inflation, there may be scope for further rate cuts in months to come.