In Focus: Monetary Policy and Monetary Policy Committee

Monetary Policy:
  • Monetary policy is the macroeconomic policy laid down by the central bank (RBI in India's case).

  • The policy impacts the size and growth rate of the money supply in an economy and regulates macroeconomic variables such as inflation, growth and unemployment.

  • The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.

  • Monetary policies are implemented through different tools, including the adjustment of the interest rates, purchase or sale of government securities, and changing the amount of cash circulating in the economy.

  • There are several direct and indirect instruments that are used for implementing monetary policy, with one the main instruments being the Liquidity Adjustment Facility (LAF).

What is Liquidity Adjustment Facility (LAF)?
  • 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.

  • Repo Rate: It is the interest rate at which the RBI provides overnight liquidity to banks against the collateral of government and other approved securities under the LAF.

  • Reverse Repo Rate: The interest rate at which the RBI absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF. Basically, banks can park their money with RBI while receiving interest on it.

Inflation targeting monetary policy framework:
  • In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.

  • The amended RBI Act also provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once in every five years.

  • Accordingly, the Central Government has notified 4 per cent 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 per cent and the lower tolerance limit of 2 per cent.

    • For example: Let's say the RBI has a target inflation rate of 4%. So, every time the retail inflation rate rises above the 4% mark, the RBI raises the cost of money i.e. the interest rate. When that happens, some people find it more advisable to take the cash out of the market and put it into banks. This way, demand reduces and inflation falls.

    • The reverse process applies when the inflation is below the 4% mark.



  • The Monetary Policy Committee (MPC) constituted by the Central Government determines the policy interest rate required to achieve the inflation target.

About: Monetary Policy Committee (MPC)
  • On the recommendation of Urjit Patel Committee, Monetary Policy Committee was created in 2016 to bring transparency and accountability in fixing India's Monetary Policy.

  • The Monetary Policy Committee of India is responsible for fixing the policy interest rate, to achieve the objectives of monetary policy.

  • Composition:

    • Three officials of the Reserve Bank of India, with Governor of RBI as Chairperson, ex officio

    • Three external members appointed by the Government of India

      • The external members hold office for a period of four years.





  • Decisions of the MPC are taken on the basis of majority, with Governor having the casting vote in case of a tie.

  • The MPC meets least 4 times a year and it publishes its decisions after each such meeting.

 
News Summary:
  • The four-year tenure of the three government-nominated members had expired on August 6.

  • Though the RBI had sought an extension of the tenure of external members until March due to the Covid situation, it was not accepted by the government as there was no such provision in the RBI Act.

  • However, the government has not yet nominated its three members on the Monetary Policy Committee (MPC).

  • As per the RBI Act, the quorum for an MPC meeting is four. This means the committee cannot meet until at least one external member is present, in addition to the three RBI representatives.

  • Consequently, the Reserve Bank of India (RBI) had to postpone the bi-monthly meeting of the MPC scheduled from September 29 to October 1.

  • It’s for the first time in recent history that the RBI had to postpone its monetary policy review.

Delay in announcement of policy rates:
  • The bi-monthly MPC meeting discusses the domestic and international scenario before finalising the repo and reverse repo rates.

  • On October 1, after its bi-monthly meeting, the RBI's Monetary Policy Committee (MPC) was supposed to announce the country’s key interest rates and the monetary policy for the next two months.




Significance:
  • Interest rates play a crucial role in the economy. Any delay in changing the rates will impact the economy as MPC sets the repo rate (the rate at which RBI lends funds to banks) and reverse repo rate (the rate at which the RBI borrows funds from banks).

  • During the covid pandemic related economic stress, the RBI has been leading from the front with quick responses through rate cuts, injecting liquidity etc. to ensure financial stability.

  • With the covid pandemic still raging, GDP growth floundering and credit offtake still slow, there is much interest in the monetary policy announcements by the RBI.

  • Experts say, in the current situation, the MPC has to be in place to formulate policy, and this delay could have been avoided by the government.

 Economics