RBI has Some Superpowers...
But, Can it Tame Inflation?
The Monetary Policy Committee (MPC) hasn't been around forever. It was established in 2016 so that the RBI can focus on inflation while the government focuses on GDP. (Check out our previous piece to dig deeper into the origin!).
But, how can MPC handle inflation for a population of 139 crores?
Well, it has superpowers (called benchmark policy rates).
Okay. But, what? And, why are we suddenly talking about it?
Because, we are living in crucial times. The decisions of this committee can determine the speed of economic revival. Exactly a week ago, the committee gathered to assess the situation. And here’s what they have to say:
Repo and reverse repo rate to be unchanged
Umm...What are these “repo” rates? And, how is this move going to help?
Let’s say you want a loan, and you go to the bank. The bank agrees to lend money to you but asks you to pay interest on it.
Now to provide us loans, the bank will need funds. Let’s say it goes to the Reserve Bank of India to borrow. Now, the RBI will charge the bank interest. This interest rate is called the repo rate.
Let’s say the repo rate is 4%. Banks will have to pay an interest of 4% to RBI, so they will charge a higher interest from you. And, that’s how they will earn money from you.
But, aren’t you thinking what this repo rate has to do with inflation?
Say RBI gives loans to banks at dirt-cheap rates. The bank will also lower the interest rates that it charges from its customers. Now, seeing the low cost of borrowings, businesses will be tempted to take loans to grow.
They will employ more people. And, people like us will have more money in hand. What will you do with that extra cash?
Buy more goodies, right? That’s what many of us will do. But, the supply of these goodies won’t increase overnight.
Seeing the demand shoot, the seller will find an opportunity to increase the price. And, that’s inflation for you.
Now, coming back to our announcements. Just about a week back RBI announced -
The repo rate will remain unchanged at 4% in June 2021, decreasing from 5.15% in October 2019 to 4.4% in March and down to 4% in May 2020.
No, the RBI does not want inflation to go up.
In a crisis situation, like we are in right now, people do not have money and so they have cut down on spending. Economic activities are falling down. Unemployment has gone up.
Low repo rate is required to ease liquidity, reduce the cost of borrowing and spending and thus bring the economy back on track. And so the RBI thinks that inflation shouldn’t really go out of hand.
What's the reverse repo then?
It’s literally the reverse of repo. Here the RBI borrows money from the banks. But, why will RBI need to borrow money?
This is again a tactical move to control the quantum of money in the hands of people. How?
If RBI starts offering higher interest rates to banks, banks will be tempted to give loans to RBI, instead of the general public. And so, this reduces the money supply in the economy. Economic activities will go down, too.
Now take a second and think, what would you do with reverse repo if you were at MPC?
Done thinking?
So here’s what RBI did. It has not changed the reverse repo rates, which is at 3.35%, decreasing from 4.9% in February 2020 to 4% in April 2020. It has kept the rates at the lower side so that banks lend more to the public (again increasing liquidity), to induce growth in economic activities.
It does not end here. MPC has another trick up its sleeve to increase liquidity. It is called the Government Securities Acquisition Program (GSAP).
As the name suggests, RBI acquires Government Securities. Why?
Well, I know you guessed it this time. It has something to do with boosting the economy. Again.
When the government needs to borrow money from the public it issues a piece of paper (instrument) called bonds.
So let’s say the government gives you a bond that says you can get Rs.100 at the end of 5 years. Along with this, the government also gives you 5 coupons of Rs. 10 each that you can claim at the end of each year. This is the interest that you earn on your loan given to the government. Your yield or return will be (10/100*100) =10%
But, that doesn’t mean that your money is locked for 5 years. You can sell this bond to others. Now, let’s say that people have several other options for investments where they can earn even higher returns. Will the demand for this bond be high then?
Of course not. So you will get a lower value for your bonds. Say someone buys it from you at Rs. 80. Just by putting Rs. 80 they will get Rs.10 every year and a full amount of Rs. 100 at the end of 5 years. They will be getting higher returns with lower investment. So the yield increases. But, why is that bad?
Because, now people will be induced to invest in government bonds. And they will cut down their investment in the bonds issued by corporates. Corporates will now start competing for the limited money available which will increase the interest rates, and thereby their expenses.
High cost of running a business will demotivate them to expand operations. The economic activities of the country will go down and no one wants that to happen.
But that’s exactly what has been happening in the economy. With the rolling out of vaccines and the introduction of government stimulus packages, people are expecting the economy to recover. And so, they are shifting their investments into risky assets such as stocks, leading to a decrease in demand for bonds. Thus, RBI will be purchasing government bonds worth Rs. 1 trillion in the June quarter (G-SAP 1.0) and Rs. 1.2 trillion in the September quarter (G-SAP 2.0) to keep interest rates under check and increase liquidity in the economy.
Isn’t it interesting? MPC’s action is no less than Thanos’ finger snap.
It can literally change the economy.
Shantanu’s take: With great power, comes great responsibility. This whole exercise of not increasing interest rates and boosting liquidity is on the assumption that the current problems in the economy are temporary, that higher inflation can be fixed; that once we open up, everything will be back to normal. And that’s a big if. With rising commodities, fuel, and food prices, inflation seems like it’s here to stay. Interest rates will have to be reversed, sooner or later. And when that happens, all hell will break loose.
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You can read the complete resolution made by the MPC in June 2021 here.
Very well framed