Context: On May 4, the Reserve Bank of India, in a surprise move, announced that the bank’s Monetary Policy Committee (MPC) had held an ‘off-cycle’ meeting at which it had decided unanimously to raise the “policy repo rate by 40 basis points to 4.40%, with immediate effect”.
The MPC had judged that the inflation outlook warranted an appropriate and timely response through resolute and calibrated steps to ensure that the second-round effects of supply side shocks on the economy were contained and long-term inflation expectations were kept firmly anchored.
RBI’s monetary policy response would help preserve macro-financial stability amid increasing volatility in financial markets.
What is the repo rate?
One of several direct and indirect instruments that are used by the RBI for implementing monetary policy.
The RBI defines the repo rate as the fixed interest rate at which it provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
In other words, when banks have short-term requirements for funds, they can place government securities that they hold with the central bank and borrow money against these securities at the repo rate.
Since this is the rate of interest that the RBI charges commercial banks such as State Bank of India and ICICI Bank when it lends them money, it serves as a key benchmark for the lenders to in turn price the loans they offer to their borrowers.
Why is the repo rate such a crucial monetary tool?
The repo rate system allows central banks to control the money supply within economies by increasing or decreasing the availability of funds.
How does the repo rate work?
As the direct loan pricing relationship
Functions as a monetary tool by helping to regulate the availability of liquidity or funds in the banking system.
For instance, when the repo rate is decreased, banks may find an incentive to sell securities back to the government in return for cash. This increases the money supply available to the general economy.
Conversely, when the repo rate is increased, lenders would end up thinking twice before borrowing from the central bank at the repo window thus, reducing the availability of money supply in the economy.
Impact of Repo Rate change on inflation
Inflation can broadly be: mainly demand driven price gains, or a result of supply side factors that in turn push up the costs of inputs used by producers of goods and providers of services, thus spurring inflation, or most often caused by a combination of both demand and supply side pressures.
Changes to the repo rate to influence interest rates and the availability of money supply primarily work only on the demand side by making credit more expensive and savings more attractive and therefore dissuading consumption. However, they do little to address the supply side factors.
What is Monetary Policy Committee?
Urjit Patel committee in 2014 recommended the establishment of the Monetary Policy Committee.
It is a statutory and institutionalized framework under the Reserve Bank of India Act, 1934, for maintaining price stability, while keeping in mind the objective of growth.
Composition: Six members (including the Chairman) – three officials of the RBI and three external members nominated by the Government of India.
The Governor of RBI is ex-officio Chairman of the committee
Functions: The MPC determines the policy interest rate (repo rate) required to achieve the inflation target (presently 4%). Decisions are taken by majority with the RBI Governor having the casting vote in case of a tie.
Repo vs Reverse repo rate
Repo rate is the rate at which the Central Bank grants loans to the commercial banks against government securities.
Reverse repo rate is the interest offered by RBI to banks who deposit funds with them.
