GS Notes

6. Economics Notes 07

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Elaborate Notes

Monetary Policy: Framework, Tools, and Contemporary Challenges

  • Evolution of the Monetary Policy Framework in India

    • Pre-reform Era (before 1991): Monetary policy was largely subservient to fiscal policy. Interest rates were administered, and tools like the Statutory Liquidity Ratio (SLR) were kept at high levels (peaking at 38.5% in 1991) primarily to finance the government’s fiscal deficit at low costs, a phenomenon economists term ‘Financial Repression’.
    • Post-reform Shift: The process of reform began with the Chakravarty Committee (1985), which recommended a shift towards targeting monetary aggregates (like M3) to control inflation. The Narasimham Committee on Financial System Reforms (1991 and 1998) was instrumental in advocating for greater autonomy for the RBI, reduction in SLR and CRR, and the introduction of market-based instruments.
    • Technical Advisory Committee (TAC) Era: Prior to 2016, the RBI Governor held the final authority on monetary policy decisions. The Governor was advised by a Technical Advisory Committee on Monetary Policy, composed of internal RBI members and external experts. However, the recommendations of the TAC were purely advisory, and the ultimate decision-making power was vested solely with the Governor.
    • The Urjit Patel Committee (2014): Officially known as the “Expert Committee to Revise and Strengthen the Monetary Policy Framework,” this committee, chaired by then-Deputy Governor Dr. Urjit R. Patel, laid the groundwork for the current regime. It made several landmark recommendations:
      1. Inflation Targeting: It proposed that inflation should be the nominal anchor for monetary policy.
      2. Target Metric: It recommended using the all-India Consumer Price Index (CPI)-Combined as the target measure, moving away from the earlier focus on the Wholesale Price Index (WPI). This was justified because CPI better reflects the cost of living for the general populace.
      3. Monetary Policy Committee (MPC): It recommended the establishment of a committee to decide the policy rate, thereby moving from a governor-centric to a committee-based decision-making process.
    • Monetary Policy Framework Agreement (MPFA) and the MPC: Following the committee’s report, the Government of India and the RBI signed the Monetary Policy Framework Agreement in 2015. Subsequently, the RBI Act, 1934 was amended in 2016 to statutorily provide for the constitution of a Monetary Policy Committee (MPC). The MPC is a six-member body (3 from RBI, including the Governor as Chairperson, and 3 external members appointed by the Government). Decisions are made by majority vote, with the Governor holding a casting vote in case of a tie. This institutional change, while promoting transparency and accountability, has also sparked debate regarding its impact on the RBI’s autonomy due to the presence of government-appointed members.

  • Inflation Targeting Regime

    • The primary objective of the monetary policy under the MPFA is to maintain price stability while keeping in mind the objective of growth.
    • The inflation target is determined by the Government of India in consultation with the RBI once every five years. The current target is 4% CPI-Combined inflation with a tolerance band of +/- 2%, effectively creating a target range of 2% to 6%.
    • If the RBI fails to meet this target for three consecutive quarters, it is considered a breach of the mandate, and the RBI must submit a report to the government explaining the reasons for failure and outlining the remedial actions it proposes to take.

  • Contextual Economic Challenges and Policy Responses

    • Post-2011 Rupee Depreciation and “Taper Tantrum” (2013): The summary’s reference to the Federal Reserve’s policy and its impact relates to the period following the 2008 Global Financial Crisis. The US Federal Reserve had engaged in Quantitative Easing (QE), an expansionary policy of large-scale bond purchases, which increased the global supply of US dollars and lowered interest rates. This led to significant capital inflows into emerging markets like India.
    • In 2013, when Fed Chairman Ben Bernanke hinted at “tapering” or rolling back QE, it triggered massive capital outflows from emerging markets. This “Taper Tantrum” led to a sharp increase in demand for dollars, causing the Indian Rupee to depreciate significantly. The depreciation made essential imports like crude oil and fertilizers more expensive, stoking imported inflation in India at a time when the economy was already grappling with a high Current Account Deficit (CAD) and slowing growth, creating a classic growth-inflation dilemma.
    • The COVID-19 Pandemic Response:
      • During the lockdown, both the government and the RBI adopted expansionary policies. The government announced a large fiscal stimulus package (Atmanirbhar Bharat Abhiyan), while the RBI implemented an accommodative monetary policy, slashing the repo rate and injecting massive liquidity through tools like Long-Term Repo Operations (LTROs).
      • Post-lockdown, a surge in pent-up demand created demand-pull inflation. This was compounded by severe global supply chain disruptions due to China’s ‘Zero-COVID’ policy and the Russia-Ukraine conflict (starting February 2022), which pushed up commodity prices (oil, food, fertilizers), leading to severe cost-push inflation.
      • This confluence of factors pushed India’s inflation above the upper tolerance limit of 6% (reaching 7.79% in April 2022), forcing the RBI and other global central banks to pivot towards aggressive contractionary policies.

Quantitative and Qualitative Tools of Monetary Policy

Monetary policy tools are broadly categorized into two types:

  • Quantitative Tools: These are general or indirect tools that influence the total volume of credit or money supply in the economy.

  • Qualitative Tools: These are selective or direct tools that regulate the flow of credit to specific sectors of the economy. Examples include margin requirements, credit rationing, and moral suasion.

  • Quantitative Tools in Detail

    1. Liquidity Adjustment Facility (LAF): Introduced based on the Narasimham Committee (1998) recommendations, the LAF is the primary instrument for modulating day-to-day liquidity in the banking system. It comprises:
      • Repo (Repurchase Agreement) Rate: The fixed interest rate at which the RBI provides overnight liquidity to banks against the collateral of government and other approved securities. An increase in the repo rate makes borrowing from the RBI more expensive for banks, which in turn leads to higher lending rates for the public, thus contracting the money supply. It is the principal policy rate that signals the RBI’s monetary policy stance. (Current rate mentioned: 6.5%)
      • Reverse Repo Rate: The fixed interest rate at which the RBI absorbs liquidity from banks on an overnight basis. During the pandemic, the RBI significantly lowered the reverse repo rate to create a wide gap with the repo rate (e.g., Repo at 4%, Reverse Repo at 3.35%), disincentivizing banks from parking excess funds with the RBI and encouraging them to lend instead.
      • Note: Since April 2022, the Standing Deposit Facility (SDF) has been institutionalized as the floor of the LAF corridor, replacing the fixed-rate reverse repo. Banks can park funds with the RBI under SDF without any collateral.
    2. Reserve Requirements: These are statutory obligations for banks that directly affect their lendable resources.
      • Cash Reserve Ratio (CRR): This is the fraction of a bank’s Net Demand and Time Liabilities (NDTL) that it must maintain with the RBI in the form of cash. Banks do not earn any interest on their CRR balances. An increase in CRR directly reduces the amount of funds available for banks to lend. (Current rate mentioned: 4.5%)
      • Statutory Liquidity Ratio (SLR): This is the fraction of NDTL that a bank must maintain with itself in the form of safe and liquid assets, such as cash, gold, and unencumbered government securities (G-secs). Historically, a high SLR created a captive market for government debt. A reduction in SLR frees up resources for banks to lend to the commercial sector. (Current rate mentioned: 18%)
    3. Open Market Operations (OMO): This refers to the outright purchase and sale of government securities by the RBI in the open market to manage systemic liquidity on a more durable basis.
      • Purchase of G-secs: Injects liquidity into the system.
      • Sale of G-secs: Absorbs liquidity from the system.
      • Operation Twist: A specific type of OMO, first conducted by the RBI in 2019, which involves simultaneously selling short-term securities and buying long-term securities. The objective is to bring down long-term interest rates and flatten the yield curve, thereby encouraging long-term investment without affecting the overall liquidity in the system.
    4. Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow an additional amount of overnight money from the RBI by dipping into their SLR portfolio up to a limit at a penal rate of interest (the MSF rate). The MSF rate is pegged above the repo rate and acts as the ceiling of the LAF corridor, serving as a safety valve against unforeseen liquidity shocks.

  • Bonds and Yields

    • A bond is a debt instrument where an investor loans money to an entity (government or corporate) which borrows the funds for a defined period at a variable or fixed interest rate, known as the coupon.
    • Bond Yield: It represents the return an investor gets on a bond. The simplest form is the current yield, calculated as: Yield = (Annual Coupon Payment / Current Market Price of the Bond).
    • Inverse Relationship between Bond Price and Yield: This is a fundamental concept. When new bonds are issued at a higher interest rate (coupon), the demand for existing bonds with lower coupons falls. To be sold, their price must decrease. As the price of the bond falls in the secondary market, its yield for a new buyer increases (since the coupon payment is fixed). Conversely, if interest rates fall, existing bonds with higher coupons become more attractive, their prices rise, and their yields fall.
    • Impact of Inflation: High inflation erodes the real return from the fixed coupon payments of a bond. Therefore, investors demand a higher yield to compensate for the inflation risk. This leads to a fall in bond prices. When bond yields rise, it becomes more expensive for the government and corporations to borrow from the market.

Prelims Pointers

  • The Monetary Policy Committee (MPC) was established based on the recommendations of the Urjit Patel Committee.
  • The legal basis for the MPC is the amended RBI Act, 1934.
  • MPC Composition: 6 members (3 from RBI and 3 appointed by the Central Government).
  • The Governor of the RBI is the ex-officio Chairperson of the MPC.
  • The Governor holds a casting vote in case of a tie.
  • The current inflation target for the MPC is 4 per cent (+/- 2 per cent).
  • The target is measured by the Consumer Price Index (CPI)-Combined.
  • The inflation target is set by the Government of India, in consultation with the RBI, once every five years.
  • Quantitative Easing (QE): An unconventional monetary policy where a central bank purchases long-term securities from the open market to increase the money supply.
  • Taper Tantrum: Refers to the 2013 surge in global bond yields and capital outflows from emerging markets after the US Federal Reserve announced it would be tapering its QE program.
  • LAF Corridor: A system where the MSF rate is the ceiling, the SDF rate is the floor, and the policy Repo rate lies in between.
  • CRR (Cash Reserve Ratio): A percentage of NDTL that banks must keep with the RBI as cash. No interest is paid on CRR.
  • SLR (Statutory Liquidity Ratio): A percentage of NDTL that banks must maintain with themselves in liquid assets like cash, gold, or G-secs.
  • OMO (Open Market Operations): Outright purchase and sale of government securities by the RBI.
  • Operation Twist: Simultaneous sale of short-term government securities and purchase of long-term securities.
  • Bond Price and Bond Yield: They share an inverse relationship. If bond price increases, yield decreases, and vice-versa.

Mains Insights

  • Fiscal and Monetary Policy Coordination

    • Challenge of Policy Divergence: Effective economic management requires a strong synergy between fiscal and monetary policy. For instance, if the RBI adopts a contractionary monetary policy to curb inflation (by raising interest rates), but the government simultaneously pursues an expansionary fiscal policy (high borrowing and spending), the two policies work at cross-purposes. The government’s borrowing can “crowd out” private investment and keep inflationary pressures high, neutralizing the RBI’s efforts.
    • Institutional Frameworks: The Fiscal Responsibility and Budget Management (FRBM) Act, 2003 was enacted to enforce fiscal discipline on the government, thereby creating a more stable macroeconomic environment for the monetary policy to operate effectively. Coordinating these two policy levers is crucial, especially in times of crisis like the COVID-19 pandemic, where a joint expansionary stance was necessary to support the economy.

  • The Inflation Targeting Debate: Suitability for India

    • Arguments for Inflation Targeting (IT):
      1. Anchor for Expectations: A clear, numerical inflation target helps in anchoring the inflation expectations of households and businesses, which in itself can help control inflation.
      2. Transparency and Accountability: The framework makes the central bank’s objectives clear and its performance measurable, enhancing its accountability. This view is supported by economists like Ben Bernanke, former Chair of the US Fed.
      3. Prevents Discretionary Errors: It reduces the scope for politically motivated or discretionary policy decisions that could lead to macroeconomic instability.
    • Arguments Against Inflation Targeting (IT) in the Indian Context:
      1. Neglect of Growth Objective: Critics argue that a rigid focus on inflation can come at the cost of economic growth, a critical priority for a developing country like India.
      2. Inability to Control Supply Shocks: A significant portion of inflation in India is driven by supply-side factors (e.g., erratic monsoons affecting food prices, global oil price volatility). Monetary policy, being a demand-management tool, is relatively ineffective in controlling such cost-push inflation.
      3. Data Reliability: The reliability and timeliness of CPI data can be a challenge, making it difficult to base policy decisions solely on this metric. Former RBI governors like Y.V. Reddy and D. Subbarao have expressed concerns about the suitability of a rigid inflation-targeting framework for India, advocating for a more flexible approach that considers multiple objectives.

  • RBI’s Autonomy and the MPC Framework

    • The shift from a governor-centric model to a committee-based (MPC) model is seen as a move towards global best practices, promoting diversity of views and robust debate.
    • However, the composition of the MPC, with three of the six members being appointed directly by the government, raises persistent questions about the de-facto independence of the RBI. There is a potential risk that government-appointed members may be influenced by the fiscal imperatives of the government, especially during election cycles, potentially compromising the primary objective of inflation control. The balance between accountability to the government and operational autonomy for the central bank remains a delicate and debated issue.

  • Conflict of Interest in RBI’s Functions

    • The RBI performs multiple roles: it is the monetary authority (mandated to control inflation), the banker to the government, and the manager of public debt. This creates a significant conflict of interest.
    • As a debt manager for the government, the RBI has an incentive to keep interest rates low to ensure that the government’s borrowing costs are minimized.
    • As the monetary authority, its mandate might require it to raise interest rates to combat inflation, which would directly increase the government’s borrowing costs.
    • This conflict was highlighted by the Financial Sector Legislative Reforms Commission (FSLRC) in 2013, which recommended the creation of an independent Public Debt Management Agency (PDMA) to strip the RBI of its debt management function, allowing it to focus exclusively on monetary policy. While a separate PDMA has not been fully established, this debate underscores a fundamental structural challenge in India’s financial architecture.

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