RBI’s Monetary Policy And The Art Of Letting It Be

Relevance: GS3 - Indian Economy and issues relating to planning, mobilization, of resources, growth, development, and employment, GS2- Statutory, regulatory, and various quasi-judicial bodies.

(Source: Indian Express, 10/07/2023)

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Why in the news?

• Recently, the RBI’s Monetary Policy Committee (MPC) decided to maintain the status quo on interest rates and retain its stance of withdrawing accommodation.
• India’s growth has continued despite challenges such as the rise in prices of crude oil, the weakening of the rupee, and food inflation due to the erratic nature of the monsoon.

What has the MPC decided?

• Interests rates: The RBI maintained the status quo on interest rates with repo rate maintained at 6.50%
  • It also continued with its stance of withdrawing accommodation.
• Inflation: High inflation is a major risk to macroeconomic stability and sustainable growth.
  • Therefore, monetary policy is focused on aligning to the 4% inflation target.
  • Core inflation had declined but risks such as volatile global food and energy prices, low reservoir levels, and poor sowing raised concerns about headline inflation.
  • Forecast for CPI inflation for the current fiscal is 5.4% and the estimated headline inflation projection for the second quarter was 6.4%.
• Liquidity: The MPC stressed the need for managing liquidity in the system by using monetary policy.
  • It also stated that Open Market Operations (OMO) would be conducted as necessary.
• Financial stability: The RBI stated that financial sector balance sheet were robust and that it would closely monitor emerging trends as financial stability is crucial for price stability and growth.
  • Banks and NBFCs were advised to strengthen their internal surveillance mechanisms and establish suitable safeguards.

What are the factors behind the MPC’s decision?

Domestic Factors

• Inflationary Pressures: The second quarter of the fiscal witnessed the emergence of some early signs of unanticipated inflation risks.
• These were mainly driven by the rising prices of vegetables, particularly tomatoes.
• Although vegetable prices have eased since then, the rise in crude oil prices is another major inflationary concern.
• Previous rate hikes, 250 basis points since May 2022, have not yet been transmitted to bank lending and deposit rates.
• Supply Shocks: Food inflation, particularly in cereals, pulses, and spices, has persisted.
• The effect of El Nino and the erratic nature of the monsoon has raised concerns over agricultural productivity and returns.
  • The southwest monsoon influences groundwater and reservoir levels for the rabi or winter crop, that is grown in largely irrigated areas.
• According to the Central Water Commission, water levels in reservoirs are suboptimal at 82% of last year’s levels and 92% of the decadal average.

External Factors

• Global Monetary Policies: Major central banks including the US Federal Reserve have adopted hawkish monetary policies in order to respond to inflationary pressures.
• Central banks, mostly in advanced economies, had to ease monetary policy rapidly to fight an economic collapse, and then hike them repeatedly to counter inflation.
• For example, policy rates have risen by 250 basis points in India as compared to 525 basis points in the US.
• Monetary policy in advanced economies must balance between tightening which poses a risk of recession and less-than-optimal tightening which could lead to entrenched inflation.
• Volatility in crude oil prices: India’s economy could be impacted by the volatility and upward trend in global crude oil prices.
• India depends on oil imports for around 85% of its consumption, which leaves it vulnerable to fluctuations in the price of crude.
• If crude prices rise, it could lead to a rise in headline inflation via the direct and indirect effects of higher production and transportation costs.
• This could also result in upside risks for the current account and fiscal deficit, and a downside risk to growth.
• Geopolitical factors and supply constraints can exacerbate oil price volatility despite the expectation that global demand will ease.

Economic Outlook

RBI approach

• India’s GDP growth has remained robust despite challenges posed by the rise in crude oil prices and erratic monsoons.
• The RBI has adopted a cautious approach due to the occurrence of supply shocks amidst healthy growth.

GDP growth

• CRISIL has lowered its GDP growth projection for India to 6% for the present fiscal on account of
  • Lowered exports due to the global slowdown
  • Reduced demand and the lagged impact of the rate hikes
  • Erratic weather and El Niño which has impacted agricultural growth
• RBI has retained its GDP growth outlook at 6.5% for this fiscal.

Inflation

• Surveys have indicated a slight increase in year-ahead business inflation and a reduction in consumer inflation expectations.
• The IIM-Ahmedabad business inflation expectation survey for July indicated a slight increase in year-ahead business inflation and no change in the August survey.
• Consumer inflation expectations eased from double to high single digits in the RBI’s household inflation expectation survey for September.

Conclusion

• The RBI's decision to maintain the status quo on interest rates has been influenced by a number of domestic and external factors.
• It has exercised caution with regard to potential supply shocks which could broaden inflationary pressures.
• India is set to become the world’s new growth engine with domestic economic activity remaining resilient.

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FAQs

MCQs

Question: If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do ? (UPSC 2020)

1. Cut and optimize the Statutory Liquidity Ratio
2. Increase the Marginal Standing Facility Rate
3. Cut the Bank Rate and Repo Rate

Select the correct answer using the code given below :

(a) 1 and 2 only

(b) 2 only

(c) 1 and 3 only

(d) 1, 2 and 3

Question: Which of the following statements is/are correct regarding the Monetary Policy Committee (MPC)? (UPSC 2017)

1. It decides the RBI's benchmark interest rates.
2. It is a 12-member body including the Governor of RBI and is reconstituted every year.
3. It functions under the chairmanship of the Union Finance Minister.

Select the correct answer using the code given below:

(a) 1 only

(b) 1 and 2 only

(c) 3 only

(d) 2 and 3 only