RBI shift on monetary policy

News: Recently, contrary to the predominant market expectations that the status quo will be maintained by RBI on the monetary policy, the Monetary Policy Committee (MPC) surprised everyone. The body has reinforced the de facto normalisation, which had already started in November 2021. 

What has been announced by the RBI? 

The Liquidity Adjustment Facility (LAF) corridor has been narrowed back to the conventional 0.25 percentage points. Earlier, the corridor was extraordinarily widened due to a pandemic in late March 2020.  

The RBI has fixed the rate of the newly introduced Standing Deposit Facility (SDF) at 3.75% . The facility will absorb excess liquidity available with the commercial banks without any requirement of collateral instruments. 

Now, the priority of the monetary policy has been changed. It will now focus on CPI inflation management (target of 4% +/- 2%), growth and financial stability. The extraordinary accommodation approach will be withdrawn.

What are the reasons for unexpected tightening? 

There has been uncertainty over growth of the Indian economy. The demand has been concentrated at the upper-income level of households. Inflation has emerged as a big concern.  

(1) Apart from high crude oil prices, commodity prices have increased across the board, say, gas, metals, minerals, commodities, food, gold, etc. This will lead to strong inflationary pressures.  

(2) India’s real GDP growth projection has been reduced from 7.8% to 7.2% for FY23 due to supply disruptions, slowing down of global economy and trade, high prices and financial markets volatility.  

(3) There seems to be demand destruction in the Indian economy as a result of continuing high inflation.  

(4) There has been an issue of financial stability. This is being challenged by uncertainty in the interest rate, and foreign exchange rates, market volatility, banking sector asset stress, and so on.  

(5) The RBI’s Open Market Operations (OMOs) are required to prevent more liquidity in the market. RBI wants money supply and system liquidity management. It is because the Central and state government’s large borrowing programme will increase the interest rates on sovereign bonds.  

What are the implications of monetary policy tightening like repo rate hike?  

First, interest rates will begin to increase. For bank borrowers, this is likely to be a very gradual process. For corporates and other wholesale borrowers, who also borrow from bond markets, this increase is likely to be faster.  

Second, around 40% of bank loans are now linked to external benchmarks (like the repo rate). Therefore, Interest rates on bank credit will rise faster.   

Way Forward 

A relatively loose fiscal policy can offset some of this reduced demand. The government can continue its subsidies to lower-income households. 

Source: The post is based on an article “RBI shift on monetary policy” published in the Indian Express on 09th April 2022.