MONETARY POLICY BY RBI

MONETARY POLICY BY RBI

Introduction

Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments under its control. Simply it refers to the control of the quantity of money available in an economy and the channels by which new money is supplied.

By managing the money supply, a central bank aims to influence inflation, the rate of consumption, economic growth, and overall liquidity.

It aims to control either the interest rate payable for very short-term borrowing (borrowing by banks) or the money supply, an attempt to reduce inflation or the interest rate, to ensure price stability and general trust of the value and stability of the nation’s currency.

Monetary policy also aims to contribute to the stability of gross domestic product (GDP), to achieve and maintain low unemployment, and to maintain predictable exchange rates with other currencies.

Under the RBI Act,1934 (as amended in 2016), RBI is entrusted with the responsibility of conducting monetary policy in India with the primary objective of maintaining price stability while keeping in mind the objective of growth.

Policy Framework

• In May 2016, the RBI Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.
• Under Section 45ZA, the Central Government, in consultation with the RBI, determines the inflation target in terms of the Consumer Price Index (CPI), once in five years and notifies it in the Official Gazette.
• Accordingly, on August 5, 2016, the Central Government notified in the Official Gazette 4% Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6% and the lower tolerance limit of 2%.
• On March 31, 2021, the Central Government retained the inflation target and the tolerance band for the next 5-year period – April 1, 2021 to March 31, 2026.
• Section 45ZB of the RBI Act provides for the constitution of a six-member Monetary Policy Committee (MPC) to determine the policy rate required to achieve the inflation target.
• Failure to Maintain Inflation Target: The Central Government has notified the two factors: (a) the average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters; or (b) the average inflation is less than the lower tolerance level for any three consecutive quarters.
• Where the Bank fails to meet the inflation target, it shall set out in a report to the Central Government: (a) the reasons for failure to achieve the inflation target; (b) remedial actions proposed to be taken by the Bank; and (c) an estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions.

Monetary Policy Committee

Section 45ZB of the amended RBI Act, 1934 provides for an empowered six-member monetary policy committee (MPC) to be constituted by the Central Government by notification in the Official Gazette. The first such MPC was constituted on September 29, 2016.

The present MPC members, as notified by the Central Government in the Official Gazette of October 5, 2020, are as under:

1. Governor of the RBI—Chairperson, ex officio;
2. Deputy Governor of the RBI, in charge of Monetary Policy—Member, ex officio;

• One officer of the RBI to be nominated by the Central Board—Member, ex officio;

1. Prof. Ashima Goyal, Professor, Indira Gandhi Institute of Development Research —Member;
2. Prof. Jayanth R. Varma, Professor, Indian Institute of Management, Ahmedabad—Member; and
3. Dr. Shashanka Bhide, Senior Advisor, National Council of Applied Economic Research, Delhi—Member.

(Members referred to at 4 to 6 above, will hold office for a period of four years or until further orders, whichever is earlier)

• The MPC determines the policy repo rate required to achieve the inflation target.
• The MPC is required to meet at least four times in a year. The quorum for the meeting of the MPC is four members.
• Each member of the MPC has one vote, and in the event of an equality of votes, the Governor has a second or casting vote.
• Each Member of the Monetary Policy Committee writes a statement specifying the reasons for voting in favour of, or against the proposed resolution.

Instruments of Monetary Policy

There are several direct and indirect instruments that are used for implementing monetary policy.

• Repo Rate:The interest rate at which the Reserve Bank provides liquidity under the liquidity adjustment facility (LAF) to all LAF participants against the collateral of government and other approved securities.
• Standing Deposit Facility (SDF) Rate:The rate at which the Reserve Bank accepts uncollateralized deposits, on an overnight basis, from all LAF participants. The SDF is also a financial stability tool in addition to its role in liquidity management. The SDF rate is placed at 25 basis points below the policy repo rate. With introduction of SDF in April 2022, the SDF rate replaced the fixed reverse repo rate as the floor of the LAF corridor.
• Marginal Standing Facility (MSF) Rate:The penal rate at which banks can borrow, on an overnight basis, from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a predefined limit (2 per cent). This provides a safety valve against unanticipated liquidity shocks to the banking system. The MSF rate is placed at 25 basis points above the policy repo rate.
• Liquidity Adjustment Facility (LAF):The LAF refers to the Reserve Bank’s operations through which it injects/absorbs liquidity into/from the banking system. It consists of overnight as well as term repo/reverse repos (fixed as well as variable rates), SDF and MSF. Apart from LAF, instruments of liquidity management include outright open market operations (OMOs), forex swaps and market stabilisation scheme (MSS).
• LAF Corridor:The LAF corridor has the marginal standing facility (MSF) rate as its upper bound (ceiling) and the standing deposit facility (SDF) rate as the lower bound (floor), with the policy repo rate in the middle of the corridor.
• Main Liquidity Management Tool:A 14-day term repo/reverse repo auction operation at a variable rate conducted to coincide with the cash reserve ratio (CRR) maintenance cycle is the main liquidity management tool for managing frictional liquidity requirements.
• Fine Tuning Operations:The main liquidity operation is supported by fine-tuning operations, overnight and/or longer tenor, to tide over any unanticipated liquidity changes during the reserve maintenance period. In addition, the Reserve Bank conducts, if needed, longer-term variable rate repo/reverse repo auctions of more than 14 days.
• Reverse Repo Rate:The interest rate at which the Reserve Bank absorbs liquidity from banks against the collateral of eligible government securities under the LAF. Following the introduction of SDF, the fixed rate reverse repo operations will be at the discretion of the RBI for purposes specified from time to time.
• Bank Rate:The rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. The Bank Rate acts as the penal rate charged on banks for shortfalls in meeting their reserve requirements (cash reserve ratio and statutory liquidity ratio). The Bank Rate is published under Section 49 of the RBI Act, 1934. This rate has been aligned with the MSF rate and, changes automatically as and when the MSF rate changes alongside policy repo rate changes.
• Cash Reserve Ratio (CRR):The average daily balance that a bank is required to maintain with the Reserve Bank as a per cent of its net demand and time liabilities (NDTL) as on the last Friday of the second preceding fortnight that the Reserve Bank may notify from time to time in the Official Gazette.
• Statutory Liquidity Ratio (SLR):Every bank shall maintain in India assets, the value of which shall not be less than such percentage of the total of its demand and time liabilities in India as on the last Friday of the second preceding fortnight, as the Reserve Bank may, by notification in the Official Gazette, specify from time to time and such assets shall be maintained as may be specified in such notification (typically in unencumbered government securities, cash and gold).
• Open Market Operations (OMOs):These include outright purchase/sale of government securities by the Reserve Bank for injection/absorption of durable liquidity in the banking system.

Frequently Asked Question (FAQ)

Under which section of RBI Act 1934, the Central Government in consultation with the RBI, determines the inflation target in terms of the Consumer Price Index (CPI), once in five years?

Section 45ZA

Which section of the RBI Act, provides for the constitution of a six-member Monetary Policy Committee (MPC) to determine the policy rate required to achieve the inflation target?

Section 45ZB

At least how many times, the MPC is required to meet in a year?

4-times.

The Central Government in consultation with the RBI, determines the inflation target in terms of the Consumer Price Index (CPI), once in ____________ years.

5 years.

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INSTRUMENTS OF MONETARY POLICY
INFLATION-EFFECTS, MEASURES & CAUSES