In its Monetary Policy Statement dated December 7, 2022, The Reserve Bank of India (RBI) has increased the policy repo rate under the liquidity adjustment facility (LAF) by 35 basis points from existing 5.90 percent to 6.25 percent. ‘’Policy Rate” means the rate for repo-transactions as specified under sub-section (12AB) of section 17 of the Reserve Bank of India Act, 1936. Accordingly, “repo” means an instrument used by the banks to borrow funds from the RBI by selling securities of the Central or State Government or specified securities of a local authority or foreign securities to the RBI with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed. An increase in the repo rate implies that the banks will have lesser inclination to borrow excess funds from the central bank and so it may be used as a tool to discourage creation of excess liquidity into the banking system.
The RBI also accepts money as deposits from banks which are repayable with interest for the purposes of liquidity management under the standing deposit facility (Section 17 (1A) of the Reserve Bank of India Act, 1936). This standing deposit facility (SDF) interest rate has now been increased from 5.65 percent to 6.00 percent. If the interest rate payable on these deposits is increased, the banks are likely to park their excess funds as deposits with the central bank and so this is used as an instrument to absorb excess liquidity available in the banking system.
The monetary policy statement also announced an increase in the marginal standing facility (MSF) rate from 6.10 percent to 6.50 percent. The MSF is a sort of penal rate at which banks can borrow from the Reserve Bank, on an overnight basis, by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a predefined limit (say 2 per cent). This provides a safety valve against unanticipated liquidity shocks to the banking system. The MSF rate is placed at 25 basis points above the policy repo rate.
Lastly even the Bank Rate has been increased from 6.10 percent to 6.50 percent. The Bank Rate is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. This rate has been aligned with the MSF rate and changes automatically as and when the MSF rate changes alongside policy repo rate changes.
RBI does a Balancing Act
There are two important observations in regard to the latest monetary policy declaration. One, the policy rates have been increased but the magnitude of percentage increase has been lower than the last four policy statements. Two, the MPC has decided to remain focused on withdrawal of accommodation to ensure that inflation remains within the target going forward, while still supporting growth.
These observations are explained with the help of the following Chart:
Thus, though the repo rate has been increasing consecutively last four sessions, yet the rate of increase in it has come down to 0.35 percent in the December, 2022 monetary policy statement.
Inflation persists at or above the upper price band
The Monetary Policy Statement observes that the headline Inflation which has persisted at or above the upper tolerance band since January 2022 may continue to be above or close to the upper threshold in the third and fourth quarter of the financial year 2022-23. It is expected that in the next financial year 2023-24 also, the inflation rate may moderate a bit yet it may still be above the target level. Under Section 45ZA of the RBI Act, 1934, the Central Government, in consultation with the RBI, determines the inflation target which is currently is fixed at 4 per cent Consumer Price Index (CPI) inflation with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent. The following Chart depicts comparative inflation data for the year 2021 and 2022:
Inflation remains top priority while still supporting growth
It is clearly observed that since inflation control is one of the primary objectives of the monetary policy, the RBI has raised the policy rates five times since May 2022 after having kept it unchanged at 4 percent for 12 consecutive monetary policy statements since June 2020 as seen in the Chart below:
Inflation is hurting globally
According to the World Economic Outlook Report released on October 11, 2022, a broad-based and sharper-than-expected slowdown is expected in the Global economic activity as inflation is at record levels of several decades. This may give rise to cost-of-living crisis leading to tightening financial conditions in most countries. The continuing war between Russia and Ukraine and the re-surfacing of COVID-19 pandemic in certain regions may further aggravate the global economic outlook. The IMF has forecasted that global growth may decelerate from 6.0 percent in 2021 to 3.2 percent in 2022 and 2.7 percent in 2023 which is the weakest growth projection since 2001 barring the global financial crisis and the acute COVID-19 pandemic phases being exceptional episodes. However, global inflation which the IMF has forecast to rise from 4.7 percent in 2021 to 8.8 percent in 2022 may as well decline to 6.5 percent in 2023 and to 4.1 percent by 2024.
The RBI monetary policy resolution has made similar observations about the global economic outlook and opines that some signs of moderation in price pressures is already seen and it may as well be fairly expected that the pace of monetary tightening get eased up. Besides there are signs of easing in sovereign bond yields and the US dollar seems to have peaked out. However, there is volatility seen in the capital flows to emerging market economies (EMEs) amid global spillovers and this may pose risks to growth prospects in such economies.
Domestic outlook seems resilient
The RBI observes that the real gross domestic product (GDP) in India has increased by 13.5 per cent year-on-year (y-o-y) in the first quarter of the current financial year followed by 6.3 per cent year-on-year (y-o-y) in the second quarter. Moreover, the economic activity is reported to be exhibiting resilience in the third quarter also across sectors.
In the agricultural sector, rabi sowing has been 6.4 per cent higher compared to a year ago as per data available on December 2, 2022 supported by good monsoon. The industry and services sectors are also in expansion mode as per the purchasing managers’ indices (PMIs).
The S&P Global India Manufacturing PMI has increased to 55.7 in November 2022 from 55.3 in the month of October, 2022 backed by falling input costs and heightened sentiments. A PMI reading of 50 indicates no change in economic activity from the previous month, while a reading above 50 reflects an expansion.
India’s foreign exchange reserves are at US$ 561.2 billion as on December 2, 2022. The Money supply (M3) has expanded by 8.9 per cent as on November 18, 2022 while bank credit increased by 17.2 per cent.
Future Course of Monetary Policy
Indian economy seems to be well poised for growth as the agricultural outlook is reported to have brightened, services sector is likely to do better on account of sustained rebound in contact-intensive sectors supporting urban consumption and the manufacturing sector may grow as indicated by robust and broad-based credit growth and government’s thrust on capital spending and infrastructure. According to the RBI’s survey, consumer confidence is improving. However, the Indian economy may continue to face the challenges posed by persistent geopolitical tensions, tightening global financial conditions and slowing external demand.
To conclude, the economic activity is considered as satisfactory and it is further expected to show resilience on the back of domestic demand even as there are indications that net exports may remain subdued due to unfavorable external demand conditions. The RBI may also evaluate the impact of monetary policy measures undertaken by it so far. The future course of the monetary policy will then depend on whether inflation contains itself within the tolerable limits or breaches it. It may also depend on how well the fiscal policy gets aligned with monetary policy in that pursuit. Also, we may look forward to the budgetary measures to support the fight against inflation by improving productivity and easing supply constraints through continual structural reform measures.
Disclaimer: This article has been published based on the secondary data collected from reliable sources and the author’s own understanding of the dynamics of Indian Monetary Policy. For making any investment decisions, the reader is advised to take expert opinion/informed view.
Reference: This article is published by the Author in the Newsletter “KnowFunda Digest” on linkedin on 15.12.2022