Monetary Policy Committee (MPC)

Relevancy

  • G.S. Paper 2
  • About Monetary Policy Committee (MPC)
  • Monetary policy- Qualitative and quantitative tools
  • Flexible Inflation Targeting Framework (FITF)

Why in news?

  • Globally, policymakers have been caught off-guard by the public health, financial, and economic dislocations triggered by Covid-19.
  • However, having learnt from the global financial crisis, many major monetary policymakers have taken aggressive measures, some even inter-meeting. In contrast, India’s MPC has been conspicuous by its absence despite the anticipation of significant one-sided hits to inflation and economic growth.
  • These will undoubtedly affect the MPC’s response function. Thus, an inter-meeting rate action was strongly justified, which would have also helped pacify nervous investors and de-stress the financial system.
  • The current crisis could slash 1-2 percentage points from full-year GDP growth, depending on the extent and longevity of shutdowns, the wave of economic damage to the business and household sectors, and the swiftness and aggressiveness of the fiscal-monetary policy reponse.

What Is Monetary Policy?

  • Monetary policy refers to the policy of the Reserve Bank of India with regard to the use of monetary instruments under its control to achieve the goals of GDP growth and lower inflation rate.
  • The RBI is authorised to made monetary policy under the Reserve Bank of India Act, 1934.
  • While managing money supply, the RBI keeps primarily two factors in mind: (1) inflation and (2) economic growth.
  • The main objectives of the monetary policy in India are to maintain the price stability, securing the financial stability and to ensure the adequate flow of credit.
  • RBI uses various monetary instruments like REPO rate, Reverse RERO rate, SLR, CRR etc to achieve its purpose.

Instruments of Monetary Policy

The instruments of monetary policy are of two types:

  • 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)

Quantitative Instruments

  • Reserve ratios: Reserve ratios are calculated over total deposits received by a commercial bank. Reserve ratios are of two types:
    • Cash reserve ratio (CRR): It is the percentage of total deposits a commercial bank is required to maintain with the RBI. According to the Banking Regulation Act, CRR cannot exceed 15% and cannot be less than 3%. The present rate of CRR as prescribed by the RBI is 4%. CRR serves two purposes. The amount deposited with the RBI as CRR acts as an assurance to the depositors that their money will be returned. Moreover, CRR can be used to manage money supply in the economy and thus inflation.
    • Statutory liquidity ratio (SLR): It refers to the percentage of total deposits that a commercial bank is required to maintain with itself in the form of liquid assets. Liquid assets are those assets that can be converted into cash within 3 months without any significant risk involved. The term liquid assets include gold, government securities, etc. According to the Banking Regulation Act, SLR should be between 15% to 40%. The present rate of SLR is 21.50%. Like CRR, SLR serves two purposes. The amount kept in the form of liquid assets can meet even the sudden high demand for return of money by depositors. Moreover, SLR can also be used to manage money supply in the economy and thus inflation.
  • Interest rate changes: Interest rate changes can be used to adjust the money supply in the following ways:
    • Bank rate: It refers to the official interest rate at which the RBI provides loans to the banking system, which includes commercial/cooperative banks, development banks, etc. Such loans are given out either by direct lending or by rediscounting (buying back) the bills of commercial banks. Thus, bank rate is also known as discount rate. Bank rate at present is 5.65%.
    • Repo rate: Under repo or repurchase agreement, the RBI lends money to commercial banks and commercial banks give government bonds to the RBI with an agreement to purchase them back. In other words, repo rate or repurchase rate is the rate at which the RBI lends money to banks for a short time period.
    • Reverse repo rate: Under the reserve repo or reverse repurchase agreement, commercial banks park their excess funds at fixed rate with the RBI and the RBI gives government bonds to commercial banks with an agreement to purchase them back. The reverse repo rate, or reverse repurchase rate, is the rate at which commercial banks lend money to the RBI for a short time period.

Difference between bank rate and repo rate:

  • Bank rate and repo rate seem to be similar because in both, the RBI lends to the banks.
  • However, repo rate is a short-term measure. It is used to adjust temporary increase or decrease in money supply.
  • On the other hand, bank rate is a long-term measure and is governed by the long-term monetary policies of the RBI.

Qualitative Measures

Qualitative measures are also called instrument of selective credit control. Selective credit control refers to influence in division of credit among various types of borrowers. Some of them are as follows:

  • Margin requirement: This refers to the difference between the securities offered and the amount borrowed from the banks. In case the RBI mandates banks to demand higher margin requirements, the amount of credit given on security reduces.
  • Moral suasion: A moral suasion is a persuasion tactic used by the RBI to influence and pressure, but not force, banks in adhering to policy. Tactics used are closed door meetings with bank directors, increased severity of inspections, appeals to community spirit, or vague threats.
  • Consumer credit regulation: This refers to the issuing of rules regarding downpayments and maximum time period of installment credit for purchase of goods.
  • Direct action: This step is taken by the RBI against the banks that do not fulfil conditions and requirements. The RBI may refuse to rediscount their papers or charge a penal rate of interest over and above the bank rate, for credit demanded beyond a limit.
  • Guidelines: The RBI issues oral, written statements, appeals, guidelines, and warnings to the banks. For instance, the RBI requests commercial banks to pass the benefits of decrease in interest rates to the final consumers.
  • Rationing of credit: The RBI controls the credit allocated by commercial banks to various sectors. For instance, the RBI mandates banks to issue 40% of their credit to the priority sector. Priority sector refers to those sectors of the economy that may not get timely and adequate credit in the absence of this special dispensation but are important for overall growth of economy. Priority sector lending is an important role given by the RBI to the banks for providing a specified portion of the bank lending to a few specific sectors such as agriculture and allied activities, micro and small enterprises, poor people for housing, students for education, social infrastructure, renewable energy, export credit and other low-income groups and weaker sections.

What is Monetary Policy Committee?

  • The Monetary Policy Committee (MPC) constituted by the Central Government under Section 45ZB. The MPC determines the policy interest rate required to achieve the inflation target.
  • Before establishment of Monetary Policy Committee, the final decision on interest rates etc. would come from RBI Governor’s desk.
  • Though there was a Technical Advisory Committee (TAC) comprising of governor as its chairman, the deputy governor as its vice-chairman and other 3 deputy governors to decide on monetary policy yet, the Governor had overriding powers upon the decision making process.
  • The TAC was advisory in nature and there was no voting system there.

Composition of Monetary Policy Committee

  • The 6 member Monetary Policy Committee (MPC) constituted by the Central Government as per the Section 45ZB of the amended RBI Act, 1934.
  • The first meeting of the Monetary Policy Committee (MPC) was held on in Mumbai on October 3, 2016.

Flexible Inflation Targeting Framework (FITF)

  • Who sets the inflation target in India: The amended RBI Act provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once every five years.
  • Flexible Inflation Targeting Framework: Now there is a flexible inflation targeting framework in India (after the 2016 amendment to the Reserve Bank of India (RBI) Act, 1934).
  • Factors that constitute a failure to achieve the inflation target:
    • The average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters, OR
    • The average inflation is less than the lower tolerance level for any three consecutive quarters.