RBI MPC 2023 | Repo rate, LAF, CRR, and all the key terms de-jargoned

Earlier when funds parked in SDF and taken from MSF on Friday, they used to get reversed on Monday but now this will get reversed on weekends.

What is monetary policy?

Monetary policy is a macroeconomic strategy implemented by the central bank. It involves the management of the money supply and interest rates, influencing the demand side of the economy. Governments use monetary policy to achieve various macroeconomic objectives, including controlling inflation, promoting consumption, fostering economic growth, and managing liquidity in the financial system.

Why the RBI is the best institution to roll out monetary policy?

The Reserve bank of India (RBI), as the issuer of currency, controller of credit extended by commercial banks, and provider of interest rate signals in the economy, holds a strategic position to impact economic activities through policies associated with these functions.

What are the main objectives of monetary policy?

The key objectives of monetary policy generally include

Price Stability: Maintaining stable prices and controlling inflation is a primary goal of monetary policy. Price stability provides a conducive environment for sustainable economic growth.

Economic Growth: While ensuring price stability, monetary policy also aims to support and promote sustainable economic growth. By influencing interest rates and money supply, the apex bank seeks to stimulate or moderate economic activity.

Interest Rate Stability: Keeping interest rates stable is vital for fostering a predictable financial environment.

Currency Stability: Maintaining stability in the home currency is essential for promoting confidence in the economy. The RBI may intervene in the currency market to stabilise exchange rates.

Financial Market Stability: Another important element is to ensure the stability of financial markets. RBI aims to check excessive volatility and disruptions in financial markets.

More significantly, the RBI uses a flexible inflation-targeting framework as part of its monetary policy. Also, the apex bank communicates its inflation targets and policies through a consultative process.

What are the monetary policy instruments?

Repo Rate: The repo rate is the interest rate at which the RBI lends money to commercial banks on an overnight basis under the Liquidity Adjustment Facility. It is a crucial policy tool used by the central bank to target inflation and ensure price stability in the economy. The decision regarding the repo rate is made by the RBI's Monetary Policy Committee (MPC).

When the repo rate is changed, it has a corresponding impact on the lending rates of commercial banks. If banks follow the RBI's lead, changes in the repo rate influence interest rates in the broader economy.

Reverse Repo Rate: The reverse repo rate is the interest rate at which the RBI borrows money from commercial banks. It is a tool used in monetary policy to manage and control the money supply in the economy. When the apex bank hikes the reverse repo rate, it becomes more attractive for commercial banks to park their surplus funds with the central bank, leading to a reduction in the money supply in the market.

Liquidity Adjustment Facility (LAF): LAF is used by the RBI to inject or absorb liquidity into or from the banking system. In 1998, it was introduced as part of the recommendations of the Narasimham Committee on Banking Sector Reforms. LAF consists of two parts: repo (repurchase agreement) and reverse repo.

When banks need liquidity to meet their daily requirements, they borrow from the RBI via the repo mechanism. The interest rate at which this borrowing occurs is called the repo rate. Conversely, when banks have surplus funds, they can park them with the RBI through the reverse repo mechanism. The interest rate at which this takes place is the reverse repo rate.

Open Market Operations (OMO): OMO is a monetary policy tool that involves the buying and selling of securities, such as government bonds, by the RBI. The central bank engages in OMO to influence the money supply and credit conditions in the economy.

When the RBI sells government securities, it aims to control the flow of credit by absorbing excess liquidity from the market.

Cash Reserve Ratio: The Cash Reserve Ratio (CRR) is the portion of bank deposits that commercial banks are mandated to keep with the RBI in the form of reserves or balances. It is a tool used by the central bank to control the liquidity in the banking system.

A higher CRR requirement means that a larger portion of a bank's deposits is kept as reserves, reducing the funds available for lending and investment. On the other hand, a lower CRR requirement increases liquidity in the banking system.

Statutory Liquidity Ratio (SLR): SLR is a regulatory requirement that mandates financial institutions, including banks, to maintain a specified percentage of their total time and demand liabilities in the form of liquid assets.

Liquid assets include non-cash forms such as precious metals, bonds, and so on. SLR is a prudential measure to ensure the solvency and stability of financial institutions by requiring them to hold a certain level of easily convertible assets.

Bank Rate: The bank rate, also known as the discount rate, is the rate at which the RBI lends funds to commercial banks or financial institutions. It serves as a benchmark for interest rates in the broader economy.

An increase in the bank rate implies higher costs for commercial banks when borrowing from the central bank. This, in turn, leads to higher borrowing costs for businesses and consumers, reducing the overall credit availability in the economy.

Policy Stance

Accommodative stance: An accommodative stance in monetary policy indicates that the RBI is inclined to expand the money supply to stimulate economic growth. This is often achieved by lowering interest rates to encourage borrowing and spending.

During an accommodative policy period, the RBI is willing to cut interest rates to make borrowing more attractive, intending to spur investment, consumption, and overall economic activity.

Neutral stance: A neutral stance in monetary policy indicates that the RBI is open to either cutting or increasing interest rates. This approach is typically adopted when the policy priority is balanced between managing inflation and promoting economic growth.

Hawkish stance: A hawkish stance in monetary policy signals that the RBI's primary objective is to maintain low inflation. During a hawkish phase, the central bank is inclined to raise interest rates to cut the money supply and, consequently, lower demand in the economy.

Calibrated Tightening: Calibrated tightening refers to a monetary policy stance where, within the current rate cycle, a cut in the repo rate is ruled out. Instead, the central bank is inclined to raise interest rates in a measured and deliberate manner.