Bimonthly RBI Monetary Policy June 2018
The Monetary Policy is reviewed by Monetary Policy Committee (MPC) of the Reserve Bank of India. This time RBI governor Urjit Patel headed the six member NPC. This was the first three-day bi-monthly policy meeting (June 06) of MPC headed by Urjit Patel. The next meeting of the MPC is scheduled on July 31 and August 1, 2018.The decision of the MPC is consistent with the ‘neutral’ stance of monetary policy in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4% within a band of +/- 2% while supporting growth.
Growth and Inflation according RBI
On the domestic front, the Central Statistics Office (CSO) released on May 31 the quarterly estimates of national income accounts for Q4:2017-18 and provisional estimates for 2017-18. Gross domestic product (GDP) growth for 2017-18 has been estimated at 6.7 per cent, up by 0.1 percentage point from the second advance estimates released on February 28. This increase in growth has been underpinned by a significant upward revision in private final consumption expenditure (PFCE) due especially to improved rural demand on the back of a bumper harvest and the government’s thrust on rural housing and infrastructure. Quarterly data suggest that the economy grew at 7.7 per cent in Q4:2017-18 – the fastest pace in the last seven quarters. Gross fixed capital formation (GFCF) growth accelerated for three consecutive quarters up to Q4.
Retail inflation, measured by the year-on-year change in the CPI, rose sharply to 4.6 per cent in April, driven mainly by a significant increase in inflation excluding food and fuel. Excluding the estimated impact of an increase in house rent allowances (HRAs) for central government employees, headline inflation was at 4.2 per cent in April, up from 3.9 per cent in March. Food inflation moderated for the fourth successive month, pulled down by vegetables due to lower than the usual seasonal increase in their prices, and pulses and sugar which continued to experience deflation. However, within the food group, inflation increased in respect of cereals, fruits, prepared meals, meat and fish.
Highlights of the Bi monthly Monetary Policy
- Repo rate under the liquidity adjustment facility (LAF) has been raised by 25 basis points to 6.25% in a first rate hike in four-and-half-years.
- Reverse repo rate under the LAF stands adjusted to 6% and the marginal standing facility (MSF) rate and the Bank Rate has been adjusted to 6.5%.
- The MPC has decided to retain the projection of GDP growth for the financial year 2018-2019 at 7.4% with risk evenly balanced around this number.
- All six members of the MPC including RBI Governor Urjit Patel and Dr Chetan Ghate, Dr Pami Dua, Dr Ravindra H. Dholakia, Dr Viral V. Acharya Dr Michael Debabrata Patra voted for 0.25% rate hike.
- RBI has projected retail inflation at 4.8-4.9% for the period of April-September and 4.7% in H2 FY19.
- RBI Governor has said that the forecast of normal monsoon for 2018-19 augurs well for the agriculture sector.
- Emerging market currencies have by and large got depreciated against the US dollar. The geopolitical risks, financial market volatility and trade protectionism will further impact domestic growth.
- According to RBI, the adherence to budgetary targets by the central government and the respective state government will ease upside risks to the inflation outlook.
- The major upside risk to the inflation path is due to continuous rise price of crude oil as Brent crude rose to $76 a barrel from a level of $67 per barrel during April meeting of MPC.
- RBI pointed that the volatility in the crude oil prices has added to uncertainty to the inflation outlook.
- Investment activity is recovering well in the context of IBC (Insolvency and Bankruptcy Code) and will further get a boost from swift resolution under IBC.
- The Reserve Bank of India’s next Monetary Policy Committee meeting is scheduled on 31 July and 1 August 2018.
About Monetary Policy Committee
The Monetary Policy Committee of India is a committee of the Reserve Bank of India that is responsible for fixing the benchmark interest rate in India. The meetings of the Monetary Policy Committee are held at least 4 times a year and it publishes its decisions after each such meeting.
The committee comprises six members – three officials of the Reserve Bank of India and three external members nominated by the Government of India. They need to observe a “silent period” seven days before and after the rate decision for “utmost confidentiality”. The Governor of Reserve Bank of India is the chairperson ex officio of the committee. Decisions are taken by majority with the Governor having the casting vote in case of a tie. The current mandate of the committee is to maintain 4% annual inflation until March 31, 2021 with an upper tolerance of 6% and a lower tolerance of 2%.
The committee was created in 2016 to bring transparency and accountability in fixing India’s Monetary Policy. Minutes are published after every meeting with each member explaining his opinions. The committee is answerable to the Government of India if the inflation exceeds the range prescribed for three consecutive months.
Goal of Monetary Policy and inflation targeting
The monetary policy aims at growth with price stability apart from promoting saving, investment and capital formation. But in recent years the primary goal of the monetary policy is “inflation targeting” or “price stability” for which MPC is accountable. Inflation targeting is a monetary policy regime in which a central bank has an explicit target inflation rate for the medium term and announces this inflation target to the public. The assumption is that the best that monetary policy can do to support long-term growth of the economy is to maintain price stability. The central bank uses interest rates, its main short-term monetary instrument.
An inflation-targeting central bank will raise or lower interest rates based on above-target or below-target inflation, respectively. The conventional wisdom is that raising interest rates usually cools the economy to rein in inflation; lowering interest rates usually accelerates the economy, thereby boosting inflation. The first three countries to implement fully-fledged inflation targeting were New Zealand, Canada and the United Kingdom in the early 1990s, although Germany had adopted many elements of inflation targeting earlier.
Understanding Repo Rate and Reverse Repo Rate
The repo rate is the rate at which the central bank lends short-term money to the banks against securities. It is more applicable when there is a liquidity crunch in the market. In contrast, the reverse repo rate is the rate at which banks can park surplus funds with the reserve bank. This is mostly done when there is surplus liquidity in the market.
Repo rate — Repo rate also known as the benchmark interest rate is the rate at which the RBI lends money to the banks on collateral of securities for a short term. When the repo rate increases, borrowing from RBI becomes more expensive. If RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate similarly, if it wants to make it cheaper for banks to borrow money it reduces the repo rate.
Reverse Repo rate — Reverse Repo rate is the short term borrowing rate at which RBI borrows money from banks. The Reserve bank uses this tool when it feels there is too much money floating in the banking system. An increase in the reverse repo rate means that the banks will get a higher rate of interest from RBI. As a result, banks prefer to lend their money to RBI which is always safe instead of lending it others (people, companies etc) which is always risky.
Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI by, whereas Reverse Repo rate signifies the rate at which the central bank absorbs liquidity from the banks. In the event of inflation, central banks increase repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.
The central bank takes the contrary position in the event of a fall in inflationary pressures. Repo and reverse repo rates form a part of the liquidity adjustment facility.
Liquidity Adjustment Facility
Reserve Bank of India’s liquidity adjustment facility of LAF helps banks to adjust their daily liquidity mismatches. LAF has two components — repo (repurchase agreement) and reverse repo. When banks need liquidity to meet its daily requirement, they borrow from RBI through repo. The rate at which they borrow fund is called the repo rate. When banks are flush with fund, they park with RBI through the reverse repo mechanism at reverse repo rate.
Marginal Standing Facility
Marginal standing facility is a window for banks to borrow from Reserve Bank of India in emergency situation when inter-bank liquidity dries up completely. Banks borrow from the central bank by pledging government securities at a rate higher than the repo rate under liquidity adjustment facility or LAF in short. Marginal Standing Facility (MSF) as a new policy was announced by the Reserve Bank of India (RBI) in its Monetary Policy (2011-12) and refers to the penal rate at which banks can borrow money from the central bank over and above what is available to them through the LAF window. MSF, being a penal rate, is always fixed above the repo rate. In MSF scheme banks can borrow overnight upto 1 per cent of their net demand and time liabilities (NDTL) i.e. 1 per cent of the aggregate deposits and other liabilities of the banks. However, with effect from 17th April 2012 RBI raised the borrowing limit under the MSF from 1 per cent to 2 per cent of their NDTL outstanding at the end of the second preceding fortnight. The rate of interest for the amount accessed through this facility got fixed at 100 basis points (i.e. 1 per cent) above the repo rate for all scheduled commercial banks. But all MSF limit and interest rate have been subject to change from time to time. The minimum amount which can be accessed through MSF is Rs.1 crore and in multiples of Rs.1 crore. ( Rs 1 crore = Rs 10 million). The application for the facility can be submitted electronically also by the eligible scheduled commercial banks. The banks used the facility for the first time in June 2011 and borrowed Rs.1 billion via the MSF.
The MSF would be the last resort for banks once they exhaust all borrowing options including the liquidity adjustment facility by pledging government securities, where the rates are lower in comparison with the MSF. The MSF would be a penal rate for banks and the banks can borrow funds by pledging government securities within the limits of the statutory liquidity ratio. The scheme has been introduced by RBI with the main aim of reducing volatility in the overnight lending rates in the inter-bank market and to enable smooth monetary transmission in the financial system.MSF represents the upper band of the interest corridor with repo rate at the middle and reverse repo as the lower band.
Bank rate is the rate charged by the central bank for lending funds to commercial banks. In other words it is the rate of interest which a central bank charges on its loans and advances to a commercial bank. Bank rates influence lending rates of commercial banks. Higher bank rate will translate to higher lending rates by the banks. In order to curb liquidity, the central bank can resort to raising the bank rate and vice versa. Whenever a bank has a shortage of funds, they can typically borrow from the central bank based on the monetary policy of the country.
There is a difference between bank rate and repo rate. Bank rate deals with loans whereas repo or repurchase rate deals with the securities. The bank rate is charged to commercial banks against the loan issued to them by central banks, whereas, the repo rate is charged for repurchasing the securities.
Interest rate corridor
Interest rate corridor has repo rate in the centre and MSF above it and reverse repo below it. This became important to define the interest rate corridor after giving up administered interest rate regime in India. To balance the liquidity, RBI uses the sole independent “policy rate” which is the repo rate (in the LAF window) and the MSF rate automatically gets adjusted to a fixed per cent above the repo rate (MSF was originally intended to be 1% above the repo rate) and reverse rate is adjusted 1% below the repo rate. MSF is at present aligned with the Bank rate. Under Section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been defined as “the standard rate at which the Reserve Bank is prepared to buy or re-discount bills of exchange or other commercial paper eligible for purchase under the Act. On introduction of Liquidity Adjustment Facility (LAF), discounting/rediscounting of bills of exchange by the Reserve Bank has been discontinued. As a result, the Bank Rate became dormant as an instrument of monetary management. It is now aligned to MSF rate and is used only for calculating penalty on default in the maintenance of cash reserve ratio (CRR) and the statutory liquidity ratio (SLR).
Base rate is the minimum rate set by the Reserve Bank of India below which banks are not allowed to lend to its customers. Base rate is decided in order to enhance transparency in the credit market and ensure that banks pass on the lower cost of fund to their customers. Loan pricing will be done by adding base rate and a suitable spread depending on the credit risk premium.