Podcast | Editor's pick of the day - What to make of the recent RBI policy decision?

Before we proceed, a quick reckoner for those of us who want to know how the RBI works on these interest rates and on monetary policy.

The Monetary Policy Committee of India is a six-member body that works with the Reserve Bank on the benchmark interest rate in the country. It was created in 2016 “to bring transparency and accountability in fixing India's Monetary Policy.” The Governor of RBI chairs the committee. Currently, that is Urjit Patel, who took over from Raghuram Rajan. The others participating in meeting are officials of the Reserve Bank and three external members nominated by the central government. One peculiar criterion is that these members are required to observe a silent period seven days prior to as well as after the rate decision for reasons of confidentiality.

The MPC meets four or more times every year. The last meeting was on April 4th and 5th. This time around, it was held from June 4th to June 6th. The two primary responsibilities of the MPC are price stability and inflation targeting. If the RBI fails to achieve inflation targets, it has to file a report with the govt. The central bank is mandated to publish a Monetary Policy Report once every six months, explaining the sources of inflation and the forecasts of inflation for the next six to eighteen months.

In simpler terms, monetary policy is how the Reserve Bank controls the supply of money, manages inflation and influences currency in our economy. This is helpful in encouraging, or curbing, liquidity and maintaining general economic stability.

The RBI used to announce monetary and credit policy twice a year but a quarterly review is the de facto minimum now. Current RBI Governor Urjit Patel favours reviewing the policy every two months. The RBI’s MPC takes after an MPC that works along similar lines for the Bank of England, as well as the FOMC or the Federal Open Market Committee under the US Fed. The Brit MPC meets every month while the FOMC meets eight times a year.

Monetary policy can be expansionary or contractionary, depending on the central bank’s stance. An expansionary policy infuses money into the financial system. A contractionary policy takes money out of the financial system. One of the main tools that a central bank has at its disposal, if it wants to alter the supply of money, is tweaking the key rates.

What are these key rates? Repo Rate, or the rate of interest at which the central bank lends to other banks for shorter periods. Reverse Repo Rate is the rate at which the Reserve Bank borrows funds from other banks in the short term. Then there is the CRR, or Cash Reserve Ratio, which is the funds that banks have to park with the Reserve bank. The RBI increases CRR only to curb surplus liquidity. Finally, there’s the Statutory Liquidity Ratio or SLR - the minimum %age of deposits banks have to maintain with the RBI. This can be in the form of gold, cash, government bonds or other securities.

The key rates are reduced when economic growth slows or the economy is in a recession. Other banks take a cue from the Reserve Bank and tweak their rates as necessary. Lower rates on loans and encourage borrowing and spending. On the other hand, rates are increased when there is greater volume of money in circulation and the economy is heating up or inflation needs to be checked. Raising rates encourages individual to save money and deters them from taking out loans.

Alright, now that we have a slightly better understanding of how monetary policy works, let’s take a look at the outcome of the MPC meeting that concluded yesterday.

The big news from the meeting, as I’ve mentioned earlier, is that the RBI has hiked Repo Rate by 25 basis points to 6.25 % and Reverse Repo rate at 6.50 %. By the way, a basis point, commonly written as bps, is a common unit of measure for interest rates. One basis point is one hundredth of a %. Essentially, 100 basis points add up to 1%.

So, yesterday, the RBI upped the Repo Rate by 25 basis points to 6.25% for te first time in four years. That’s a 0.25% increase. It seems like the Reserve Bank has decided to play along with what the bond markets have been suggesting - increasing its repo rate to align with market rates after a prolonged pause. All members of the MPC voted in favour of the rate hike. The committee also hiked the reverse repo to 6 %. The MPC has also held its neutral stance on monetary policy, staying with the objective of achieving a medium-term target for consumer price index inflation of 4 %. Urjit Patel said the RBI’s rate decisions are not driven by currency movement but by the impact of these developments on inflation, which the bank has been mandated to keep at 4%, with a two %age point band on either side. This decision was contrary to market expectations that the RBI would hold rates steady while changing its stance from neutral to hawkish. Some had expected the central bank would wait until August before hiking the key repo rate. The hike in the repo rate is likely to make interest rates on loans dearer as it will make borrowing expensive for banks, and they may charge customers more.

The RBI now expects average inflation for 2018-19 to be 4.8-4.9% during the first half and 4.7% during the second half. In April, the bank had forecast an average inflation around 4.7-5.1% for the first half of the current fiscal, thereafter slowing to 4.4%. Inflation has stayed above the central bank’s medium-term target of 4% for the past six months.

The rate hike may not result in an immediate increase in deposit or lending rates as some lenders have already increased rates. Some bankers said the RBI’s move to include a higher proportion of statutory liquidity ratio (SLR) securities under liquidity coverage ratio might end up keeping short-term rates in check.

“RBI’s decision to allow banks to dip into SLR will improve liquidity in the system because of reduced demand for government securities. This will result in short term rates cooling off. We, therefore, do not expect deposit rates to go up in the immediate future. Since MCLR is dependent on one-year deposit rate, a further hike in lending rate looks unlikely,” said CV Nageswar, deputy MD of SBI.

The central bank also spoke about inflation firming up in several pockets like transport and communication, clothing, household goods and services, health, recreation, education, and personal care and effects. A recent RBI survey of households reported a significant rise in households inflation expectations, by around 90 basis points three months from now, and 130 bps one year from now. A significant shift in the inflation outlook is that food price inflation has been benign, thanks to the food management by the government, but global factors such as crude are exerting greater pressure. Since the last meeting in April, the price of the crude oil has shot up from $66 a barrel to $74. Combined with an increase in other commodity prices globally, this has caused a firming up of input cost pressures as reported by a survey of manufacturing firms.

The RBI maintained its bullishness on growth in the near term, but didn’t tinker with the overall growth forecast. It did allude to a sharp acceleration in investment and construction activities in recent times. The central bank is optimistic about a recovery in exports in light of buoyant worldwide demand, and was upbeat about rural and urban consumption gaining strength.

Some analysts expect another rate hike in the future. “We remain confident that this will be a shallow rate hike cycle if the present conditions do not deteriorate significantly. We expect RBI to hike by another 25 bps in the August policy but the call will hinge on how crude and INR movements pan out over the next few months, as well as the extent of MSP hikes,” said Suvodeep Rakshit of Kotak Institutional Equities, according to Mint.

Coming to housing now, in a bid to encourage affordable housing, loan limits for priority sector lending were raised from Rs28 lakh to Rs35 lakh in metropolitan centres for houses that cost up to Rs 45 lakh. Loan limit has also been increased from Rs20 lakh to Rs25 lakh in other centres where the cost of the house is up to Rs 30 lakh. Real estate companies were not impressed by the rate hike. Jaxay Shah, President, CREDAI National, lamented that “The Real Estate Industry was expecting a reduction in Repo rate by RBI. This decision to hike the Repo rate by 25 basis points may lead to suppressed growth in the Indian real estate sector… We hope that this move will not have any negative implications for the beneficiaries under PMAY in the form of increased borrowing costs. Indian realty requires lower rates to provide further thrust to ‘Housing for all by 2022’…”

The RBI also took note of the level of NPAs in the low-ticket affordable loan segment. “After a careful analysis of the Housing Loans data, it has been observed that the level of NPAs for the ticket size of up to Rs 2 lakh has been high and is rising briskly,” the Reserve Bank said, adding “Banks need to strengthen their screening and follow up in respect of lending to this segment.”

The central bank retained Gross Domestic Product, or GDP, growth for the financial year 2018-19 at 7.4%. The bank projected India's GDP growth at 7.5-7.6 % in the first half, and 7.3-7.4 % in the second half. "Gross domestic product (GDP) growth for 2017-18 has been revised and estimated at 6.7 % backed by an all-time high production of food grains and horticulture, strengthening of industrial growth and resilient services sector activity," RBI head Urjit Patel said.

The government welcomed the RBI’s neutral stance as one that could help steady the markets and dampen uncertainties. The RBI’s neutral stance, as Patel pointed out, allows it to keep all options open.