What is Monetary Policy?
- Monetary policy is the process by which the RBI controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability.
- Quantitative Instruments: General or indirect (Cash Reserve Ratio, Statutory Liquidity Ratio, Open Market Operations, Bank Rate, Repo Rate, Reverse Repo Rate, Marginal standing facility and Liquidity Adjustment Facility (LAF))
- Qualitative Instruments: Selective or direct (change in the margin money, direct action, moral suasion).
Recent trends: RBI a few ago released its monetary policy report (MPR)
- The repo rate (the rate at which the RBI lends short-term funds to commercial banks) stands at 4.0 percent and the reverse repo rate (the rate at which the RBI borrows) stood at 3.35 percent.
- As per RBI, transmission to bank lending rates has improved as evident from the decline in the lending rate of banks on fresh loans.
- Rise in food Inflation owing to floods in eastern India, lockdown-related disruptions and cost-push pressure, etc.
- Global financial market volatility caused by the impact of the COVID-19 is most likely to exert pressure on the Indian rupee.
- Real Gross Domestic growth will remain negative for the whole 2020-21 period.
|Monetary Policy Committee:|
The idea of MPC was mooted by Urjit Patel Committee.
- Informal Indian economy: The monetary policy affects only around 60% of loans/credit in the Indian economy which are sourced from formal channels (Banks and NBFCs).Challenges to Monetary policy functions of RBI:
- Supply chain disruptions: The MPC uses CPI inflation to adjusts its policy rates. However, the CPI doesn’t factor the rise in inflation driven by supply-chain dislocations. For example, restriction on movement resulted into a shortage of essentials.
- Weak policy transmission: Both the government and the RBI are concerned that the cumulative easing has not yet been reflected in the lowering of their lending rates by banks.
- Limitation of Inflation targeting: Inflation has been accompanied by declining borrowing in the formal sector likely affecting investment leading to rise in unemployment (according to NSSO, unemployment in India has been highest in the last 45 years).
- Triangular balance-sheet: In the aftermath of the IL&FS default in 2018, an additional dimension of liquidity and solvency of the NBFC sector has been added to the prevailing twin balance-sheet problem. Borrowing easy money cannot solve governance issues.
- Gold economy: The Indian household saves in gold/jewelry rather than financial instruments. This curtails RBI from effectively circulating money in the economy.
Is Inflation targeting a good policy?
- It is a monetary policy strategy used by central banks to maintain inflation within a specific range.
- Narasimham (2000) and Rajan (2007) Committees recommended the implementation of inflation targeting in India.
Inflation targeting as a good policy
- It increases the transparency and credibility of the central bank consequently allowing it to carry out its monetary policy more effectively.
- It helps to stabilize inflationary expectations in an uncertain future.
- Increases the focus on domestic considerations and enables quick response to domestic economy shocks.
Limitations of Inflation targeting policy
- The policy doesn’t address the sudden shocks in the economy and inefficient transmission mechanisms.
- Too much weight to inflation stabilization might prove detrimental to the stability of real economy and other growth objectives.
- Requirement of Number of preconditions like well-developed technical infrastructure for forecasting, modelling and data availability etc.
- India lacks suitable conditions for successful implementation of inflation targeting. For example, lack of adequately developed financial markets, confidence of global capital markets is low, independence of the RBI etc.
- Policy of inflation targeting will lead to highly unstable and inappropriate exchange rate.
Need for independent MPC:
- To form credible governance policy: RBI should be independent to decide on the precise corrective action for banks with high NPAs, the desirable state of liquidity and the prudential norms to be observed by banks.
- To ensure low and stable inflation: For instance, Governments use pro populist policy before elections to provide a short-term boost to growth. This often leads to long-term inflation.
- Sustain Credit availability: To ensure adequate flow of money and credit to required areas.
- To prevent sudden appreciation and depreciation of currency. For example, In Turkey lira had depreciated over 80% against the dollar in the 12 months due to government interference.
- Sustainable Investments: Independent MPC will boost the investors’ confidence and will enhance credit ratings there by attracting more investments.
- To avert crisis: Mismanagement between fiscal and monetary policy led to increased Sovereign debt in developing economies. For Example, Greek Crisis.
- Develop a legal process to ascertain RBI’s responsibilities and accountability.
- Ensuring RBI’s autonomy: The governor should be made responsible and accountable to Parliament. The RBI act should be amended to provide a guaranteed tenure of the governor and deputy governors for their effective functioning.
- Change in policy: There is need to look at an indicator of inflation that excludes food and fuel and include structural factors responsible for price rise.
- Cooperation between Government and RBI: There should be mutual cooperation and coordination between RBI and Government in large at public interests for an efficient and sustainable economy.