The Reserve Bank of India (RBI) was established by the Reserve Bank of India Act in 1934. The Act vests in RBI the powers to operate the monetary policy framework of the country. It also defines the primary objective of monetary policy as “maintaining price stability while keeping in mind the objective of growth”. Maintaining price stability, that is inflation, is pivotal for achieving sustained growth, and with the current conditions prevailing around the world, it has become all the more important to keep prices under check.
Tools to Control Inflation
One of the pivotal functions of the RBI is that of the controller of credit. Credit money, the money lent out by the financial institutions, forms the most important part of the money supply. Money supply, in turn, has important implications for the economic stability of a country. For these reasons, the RBI can control inflation by controlling the credit in the economy. The first and foremost instrument that the RBI uses for inflation control is the ‘Policy Rate’ (popularly known as the Repo Rate). Repo rate is the interest rate at which the Reserve Bank provides overnight liquidity to banks (against the collateral of government and other approved securities). By setting the repo rate, RBI controls the borrowing rates of the banks. When RBI wants to control inflation, the rates are increased. Therefore, the borrowing costs for the banks and other lenders increase. They pass this increased cost on to their customers by charging a higher interest rate to lend money. This reduces the demand for money in the economy and helps in controlling inflation. Another tool is the ‘Reverse Repo Rate’. It is the rate at which RBI borrows money from commercial banks. An increase in this rate can drain money out of the banking system (i.e. reduce money supply). Another instrument is the ‘Bank Rate’, which is the rate at which RBI buys or rediscounts bills of exchange or other commercial papers. When the bank rate is increased, it will have a similar impact as the repo rate has on inflation control.
The central bank can also use variable reserve requirements, Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), to control credit. CRR is the balance that a commercial bank is required to maintain with RBI in the form of cash reserves. SLR is the share of its total deposits that a bank has to maintain in the form of liquid assets, such as gold and government securities. By changing these ratios, RBI can control credit in the economy. If the Bank wants to, say, discourage credit, (so as to control inflation) it can increase these ratios. Raising these rates will reduce the surplus cash reserves that the banks could offer as credit. These two statutory requirements are vital. The repo rate will successfully manifest into an inflation controlling tool because of the existence of these requirements. A commercial bank will borrow from RBI when it has a dearth of funds to meet the CRR and SLR requirements. If the banks could meet the requirements without borrowing from the RBI, the transmission of the monetary policy becomes uncertain (commercial banks may not pass to their customers the benefits of rate cuts by the RBI). Another monetary policy tool is the ‘Liquidity Adjustment Facility’ (LAF). The LAF consists of overnight as well as term repo auctions. The aim of term repo is to develop “an inter-bank term money market, which in turn can set market-based benchmarks for pricing of loans and deposits, and hence improve the transmission of monetary policy”. RBI can also indulge in ‘Open Market Operations’ (OMO) to affect the money supply in an economy and thereby the inflation. These operations are direct sales and purchases of government securities so as to absorb or inject liquidity into the economy, respectively. OMOs help in altering the quantity of money in circulation.
The Monetary Framework
An agreement, which was later incorporated into the RBI Act, was signed in 2015 by the RBI and the Central government to formulate a new monetary framework. By this, India had adopted flexible inflation targeting as a mandate for RBI and the setting up of a Monetary Policy Committee (to set the policy rate). This new framework specified that the RBI should conduct inflation-targeting using the policy rate. This is a significant move away from the erstwhile approach of a multiple indicators approach where inflation control and economic growth were given equal priority. An inflation-targeting approach is one where the Central Bank tries to maintain inflation at a pre-decided level; or within a pre-decided band. However, this move has faced criticism. Concerns were raised as to how effective can the Reserve Bank be in controlling inflation and about the ramifications of attempting such control.
Pulapre Balakrishnan, a noted economist, points out that since 2008 inflation recorded an upward shift for about five years. He said, “It would be difficult to square this (the rise in inflation) with the suggestion that it reflects the Bank’s efforts to maintain growth, for growth has actually been lower in this period”. Dr V Anantha Nageswaran, a member of the PM Economic Advisory Council, quoted how research from New Zealand indicated “even firms did not form their inflation expectations based on the Central Bank’s inflation target and monetary policy framework”. He further added that Central Banks can neither control economic growth nor inflation, but only credit growth. He suggested that Central Banks should redefine their mandate to control the ‘overheating’, which manifests into credit growth, asset markets, trade deficits, and (sometimes) inflation; and consequently, return to the “multiple indicators approach”. There is also an increasing consensus among economists that the high inflation in India is primarily because of supply-side rigidities, food and fuel prices, and high fiscal expansion.
One must understand that the Central Banks hold a greater sway on the financial and money markets; and by that, they can significantly influence these two markets. Therefore, they are better equipped to influence risk-taking behaviour in the asset market. However, monetary policy is less powerful in determining the long-term performance of an economy. Monetary policy, for instance, can hardly increase the aggregate demand in the economy over the long run. Former New Zealand Central Bank Governor Graeme Wheeler remarked, “even in the shorter term, monetary policy’s influence may be low in an environment where debt levels are high and where there is considerable uncertainty about economic prospects”. It is, perhaps, time for India to find a new monetary framework.
Subscribe to The Pangean
Get the latest posts delivered right to your inbox