NAVIGATING INFLATION: UNDERSTANDING THE ROLE AND STRATEGIES OF THE RESERVE BANK OF INDIA

 BY-KAUSTUBH  SHINDE                                                                                                                                                                                    

ABSTRACT

This research paper explores the diverse strategies utilized by the Reserve Bank of India (RBI) to address the ongoing economic challenge of inflation. It highlights the crucial role of RBI in upholding price stability while promoting economic development. The analysis delves into the various monetary tools employed by the RBI, including the Liquidity Adjustment Facility (LAF), Repo Rate, Reverse Repo Rate, among others, to effectively manage liquidity and mitigate inflationary pressures. Furthermore, it emphasizes the reasoning behind the RBI's prudent approach to currency circulation during periods of inflation, drawing parallels from global instances like Venezuela; and offers a comprehensive insight into the RBI's efforts to guide the Indian economy towards sustainable progress and stability.

KEYWORDS 

Reserve Bank of India (RBI), inflation, monetary policy, liquidity management, central banking, economic stability, monetary instruments

INTRODUCTION

Inflation, the persistent increase in the overall price level of goods and services, presents a significant challenge to global economic stability. As the central bank of India, the Reserve Bank of India (RBI) plays a crucial role in maintaining monetary equilibrium and fostering favorable conditions for economic growth. With a rich history dating back to the early 1900s, the RBI has emerged as a guardian of India's economic resilience, navigating through periods of inflation and deflation.

There is a need to understand the diverse strategies employed by the RBI in managing inflation, highlighting the intricate relationship between monetary policies and economic variables. RBI,a stronghold of monetary prudence, has core responsibilities in regulating currency issuance, maintaining reserves, overseeing the credit system, all aimed at preserving price stability.

This paper examines the array of monetary tools utilized by the RBI, ranging from the Liquidity Adjustment Facility (LAF) to Open Market Operations (OMOs), analyzing their effectiveness in curbing inflationary pressures. Furthermore, it elucidates the rationale behind the RBI's cautious approach to currency issuance during periods of inflation, emphasizing the dangers of unchecked money supply expansion, as evidenced by global case studies.

RESEARCH OBJECTIVE

To understand the monetary policies implemented by RBI for steady cash flow in the economy.

HYPOTHESIS

The RBI’s adept utilization of monetary policy instruments, coupled with its cautious approach towards currency issuance during inflationary episodes, plays a pivotal role in curbing inflationary pressures and fostering sustainable economic growth in India.

RESEARCH METHODOLOGY

A doctrinal approach was undertaken for this review, information was obtained from published research, articles, thesis, and other literary sources.

RBI

The central bank of India is known as the RBI, that is the Reserve Bank of India. Central banks, which are a relatively new concept, were established around the early 1900s. RBI was created based on the recommendations of the Hilton Young Commission and its functioning is governed by the Reserve Bank of India Act, 1934. It officially started its operations on April 1, 1935.

The main objectives of the RBI are to regulate the issuance of banknotes, maintain reserves to ensure monetary stability, and manage the credit and currency system of the country. When it first began operating, the RBI took over the responsibilities of the Controller of Currency from the government and the management of government accounts and public debt from the Imperial Bank of India. The existing currency offices in various cities became branches of the Issue Department, while offices of the Banking Department were established in different locations.

Following liberalization, RBI has refocused on its core central banking functions, including Monetary Policy, Bank Supervision and Regulation, and overseeing the Payments System, while also working towards enhancing the financial markets.

The central bank uses a range of policy instruments to influence the cost and availability of money in the economy, with the ultimate aim of promoting economic growth and maintaining price stability.

INFLATION 

Inflation refers to the upward movement of prices, resulting in a decrease in purchasing power over time. The decline in purchasing power can be measured by the average increase in prices of a specific set of goods and services over a certain period. This increase in prices, usually expressed as a percentage, signifies that the same amount of currency can purchase fewer goods and services compared to previous periods. In contrast, deflation occurs when prices decrease and purchasing power rises.

During inflation the supply of money in the economy rises, this leads to a rise in the price of commodities. RBI being a government's bank formulates the monetary policies to regulate cash flow in the economy which helps to control the inflation.

WHY NOT PRINT MORE MONEY TO TACKLE INFLATION?

RBI being the apex bank of India with the authority to print more currency in India, does not pump more currency in the Economy because- 

Loss of Confidence in Currency: Excessive money printing by a central bank can result in a loss of confidence in the currency's value, as people anticipate further depreciation of its purchasing power. This can lead to a decrease in demand for the currency, creating a cycle where individuals rush to spend money quickly, driving prices up.

Supply-Demand Imbalance: If the economy's productive capacity remains stagnant while the money supply grows, it can result in an excess of money chasing a limited supply of goods, causing prices to rise further.

Wealth Redistribution: Inflation stemming from excessive money printing can disproportionately impact savers and those on fixed incomes, as the value of their savings and earnings diminish rapidly. This can exacerbate income inequality and social unrest.

Global Ramifications: Excessive money printing can lead to a devaluation of the currency on the international stage, making imports more costly and potentially causing balance of payment issues. This can exacerbate inflationary pressures and undermine economic stability.

This can also be understood by the example of Venezuela, a country once prosperous thanks to its abundant oil reserves. Venezuela experienced a decline in its economy under the socialist regime of Hugo Chavez. The economy was further weakened by the 2003 labor strike at the state-owned oil company. In response to these challenges, Chavez implemented measures such as currency pegs and import controls, which unfortunately exacerbated future economic crises. By 2015, fiscal deficits had surpassed 20%, exacerbated by dwindling foreign reserves and a decline in US investment. The situation was further aggravated by sanctions that restricted access to foreign currency. This led to hyperinflation, with the cost of a cup of coffee reaching over 2,000,000 bolivars and an annualized inflation rate exceeding 1,200,000%. 

According to experts, Venezuela's economy began to experience hyperinflation during the first year of Nicolás Maduro's presidency. Potential causes of the hyperinflation include heavy money-printing and deficit spending. Hence, printing money is not an option to tackle inflation.

MONETARY POLICY OF RBI

“…the primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth.”

The Monetary Policy Committee (MPC) is a committee established by the Central Government and headed by the Governor of RBI. Its primary objective is to determine the benchmark policy interest rate (repo rate) in order to control inflation within a specific target range. The RBI governor, with the assistance of the internal team and the technical advisory committee, oversees the decision-making process for monetary policy.

Prior to the formation of the committee, the Governor of RBI made the key decisions regarding interest rates independently. The creation of the MPC was a step towards enhancing transparency and accountability in shaping India's Monetary Policy, as mandated by the Reserve Bank of India Act, 1934. The committee is required to meet at least four times a year, and after each meeting, the monetary policy is published, with each member providing their individual perspectives.

The MPC convened for its forty-seventh meeting from February 6-8, 2024, as per the provisions of Section 45ZB of the RBI Act, 1934.

On the basis of an assessment of the current and evolving macroeconomic situation, the MPC at its meeting on (February 8, 2024) decided to:

Keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.50%. Consequently, the standing deposit facility (SDF) rate remains unchanged at 6.25% and the marginal standing facility (MSF) rate and the Bank Rate at 6.75%.

The MPC also decided to remain focused on withdrawal of accommodation to ensure that inflation progressively aligns to the target, while supporting growth. These decisions are in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4 per cent within a band of +/- 2%, while supporting growth

MPC also decided by a majority (5 out of 6 members) to remain focused on the withdrawal of accommodation to ensure the inflation progressively aligns with the target while supporting growth. Monetary policy must continue to be actively disinflationary,  as said by RBI Governor Shaktikanta Das in his statement. RBI has maintained its inflation projection at 5.4% for 2023-2024. CPI inflation is predicted to be 4.5% for the upcoming fiscal year 2024-2025, with Q1 at 5%, Q2 at 4%, Q3 at 4.6%, and Q4 at 4.7%.

MONETARY POLICY INSTRUMENTS-

The RBI manages inflation and deflation through the utilization of a range of monetary policy instruments including Repo Rate, Reverse Repo Rate, Bank Rate, Open Market Operations (OMO), Statutory Liquidity Ratio (SLR), Cash Reserve Ratio (CRR), Liquidity Adjustment Facility (LAF), and Market Stabilization Scheme (MSS). Inflation occurs when the prices of goods and services rise over a specified period, typically a year.

1. LIQUIDITY ADJUSTMENT FACILITY (LAF): 

The LAF refers to RBI’s operations through which it injects/absorbs liquidity into/from the banking system. It consists of overnight as well as term repo/reverse repos, SDF and MSF. Apart from LAF, instruments of liquidity management include outright OMOs, forex swaps and MSS.

2. LAF CORRIDOR: 

The LAF corridor has the MSF rate as its upper bound (ceiling) and the SDF rate as the lower bound (floor), with the policy repo rate in the middle of the corridor.

3. STANDING DEPOSIT FACILITY (SDF) RATE: 

In 2018, the amended Section 17 of the RBI Act empowered the RBI to introduce the SDF- an additional tool for absorbing liquidity without any collateral.

The RBI accepts non collateralized deposits from all LAF participants on an overnight basis at a certain rate. The SDF serves as a financial stability tool and plays a role in liquidity management. The SDF rate is set at 25 basis points lower than the policy repo rate. Since its implementation in April 2022, the SDF rate has taken over the fixed reverse repo rate as the lower limit of the LAF corridor. The interest rate in India is determined periodically by the RBI, with the current rate set 20 basis points below the policy repo rate. The SDF transactions will be conducted through the RBI eKuber system, utilizing electronic methods.

HOW SDF WORKS- 

Typically, commercial banks hold accounts with the central bank to facilitate the deposit or withdrawal of funds for managing their liquidity requirements. When  there is an excess of liquidity in the banking system, potentially leading to inflationary risks, the central bank aims to absorb some of this surplus liquidity to uphold price stability.

 SDF offers commercial banks a platform to park their extra funds with the central bank. SDF enables banks to deposit funds directly with the central bank without such collateral obligations.

Commercial banks may opt to utilize the SDF based on their evaluation of their liquidity status and the current market environment. Through depositing funds via the SDF, banks effectively decrease the liquidity available in the banking system, aiding in the management of inflationary risks and the stabilization of interest rates. Current SDF rate is 6.00%.

4. MARGINAL STANDING FACILITY (MSF) RATE: 

The MSF refers to the facility under which scheduled commercial banks can borrow an additional amount of overnight money from the central bank over and above what is available to them through the LAF window by dipping into their SLR portfolio up to a limit.

The penal rate at which banks can borrow, on an overnight basis, from the Reserve Bank by dipping into their SLR portfolio up to a predefined limit (2%). 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.

Objectives of MSF-

The MSF  has been introduced by RBI with the aim of reducing volatility in the overnight lending rates in the inter-bank market and to enable smooth monetary transmission in the financial system

5. MAIN LIQUIDITY MANAGEMENT TOOL: 

A 14-day term repo/reverse repo auction operation at a variable rate conducted to coincide with the CRR maintenance cycle is the main liquidity management tool for managing frictional liquidity requirements.

6.FINE TUNING OPERATIONS: 

The main liquidity operation is supported by fine-tuning operations, overnight and/or longer tenor, to tide over any unanticipated liquidity changes during the reserve maintenance period. In addition, the RBI conducts, if needed, longer-term variable rate repo/reverse repo auctions of more than 14 days.

7. REPO RATE: 

The Repo Rate, also known as Repurchase Agreement or Repurchasing Option, is the interest rate at which commercial banks borrow money from the RBI by selling qualifying securities. It is the interest rate at which RBI provides liquidity under the LAF to all LAF participants against the collateral of government and other approved securities. In India, the current repo rate set by the RBI stands at 6.50%. The most recent update on the repo rate was on 8th February 2024, where it was maintained at the same level.

An agreement is made between the RBI and commercial banks to repurchase the securities at an agreed price. This process is typically used by banks when they require additional funds or need to ensure liquidity during uncertain market conditions. The RBI uses the repo rate as a tool to regulate inflation.

How it works -

During inflation, RBI raises the repo rate, indicating that banks borrowing from the central bank will be subject to higher interest rates. This acts as a deterrent for banks to borrow money, subsequently reducing the availability of money in the market and counteracting inflation. Conversely, during a recession, the repo rates are lowered.

On 6th Feb 2020 Repo rate was 5.15% and changed to 6.50% on 8th June (26.21% change). The change in repo rate affects changes rate of interest on loans, higher the repo rate higher the interest consumer has to pay on loans. The rate on interest in Feb 2020 was 7.60% and in Feb 2024 it is 8.00% (Marginal Cost Lending Rates)

8. REVERSE REPO RATE: 

The interest rate at which RBI absorbs liquidity from banks against the collateral of eligible government securities under the LAF. Following the introduction of SDF, the fixed rate reverse repo operations will be at the discretion of the RBI for purposes specified from time to time. During inflation, the RBI raises the reverse repo rate to incentivize banks to deposit more funds with the central bank, reducing the amount of funds available for lending and borrowing by banks; helping curb inflation. Current reverse repo rate is at 3.35%.

9. BANK RATE: 

The Bank rate in India is the rate at which the RBI lends to commercial banks without requiring any security. It acts as the penal rate charged on banks for shortfalls in meeting their reserve requirements (cash reserve ratio and statutory liquidity ratio).  Bank Rate is published under Section 49 of the RBI Act, 1934. It is aligned with the MSF rate and changes automatically as and when the MSF rate changes alongside policy repo rate changes. 

Unlike Repo Rate, there is no collateral involved in this type of loan. The RBI sets the Bank Rate, which is typically higher than the Repo Rate in order to control liquidity in the market.

The central financial authority of a nation is responsible for setting the interest rate, which plays a crucial role in regulating the money supply and the banking sector. Typically, this rate is adjusted on a quarterly basis. When the interest rate changes, it sets off a chain reaction that impacts various aspects of the economy. Fluctuations in the interest rate directly influence stock market prices. Moreover, a shift in the bank rate also affects customers, as it alters the rates at which they can obtain loans. The current Bank Rate is 6.75% (10 March 2024)

10. CASH RESERVE RATIO (CRR): 

Banks operating in India are mandated to maintain a specific percentage of their deposits in the form of cash reserves. Instead of holding this cash physically, banks deposit it in currency chests at the RBI, which is considered equivalent to holding cash on hand. This mandated ratio, known as the CRR, is set by the RBI.

It is the average daily balance that a bank is required to maintain with the RBI  as a percent of its net demand and time liabilities (NDTL), as on the last Friday of the second preceding fortnight, that the Reserve Bank may notify from time to time in the Official Gazette.

For instance, if a bank's deposits increase by Rs. 100 and the CRR is 9%, the bank must hold Rs. 9 with the RBI, leaving only Rs. 91 available for investments and lending purposes. As the CRR increases, the amount available for lending and investment decreases. By adjusting the CRR, the RBI can influence the amount of funds that banks can lend out, making it a key tool for controlling liquidity.

11. STATUTORY LIQUIDITY RATIO (SLR): 

Every bank shall maintain in India assets, the value of which shall not be less than such percentage of the total of its demand and time liabilities in India as on the last Friday of the second preceding fortnight, as the RBI may, by notification in the Official Gazette, specify from time to time and such assets shall be maintained as may be specified in such notification (typically in unencumbered government securities, cash and gold).

Each financial institution must uphold a specific percentage of their NDTL as liquid assets in the form of cash, gold, and unencumbered approved securities by the end of each business day. This ratio is referred to as the SLR. The RBI has the authority to raise this ratio to a maximum of 40%. A rise in SLR also limits the bank's ability to inject more funds into the economy.

Net Demand Liabilities include accounts such as savings and current accounts, where funds can be withdrawn at any time. Time Liabilities, consist of accounts like fixed deposits where funds cannot be immediately withdrawn but must be held for a specific period.

12. OPEN MARKET OPERATIONS (OMOS): 

These include outright purchase/sale of government securities by the Reserve Bank for injection/absorption of durable liquidity in the banking system. 

CONCLUSION

The RBI serves as a stronghold against the volatile waves of inflation, utilizing a wide range of monetary tools and strategies to protect economic stability. Through careful management of liquidity and thoughtful policy creation, the RBI strives to navigate the equilibrium between price stability and economic growth. The RBI remains steadfast in its dedication to creating an environment that fosters sustainable development. As India's economic landscape continues to evolve, the RBI's role as a guardian of monetary prudence becomes even more significant, emphasizing the importance of vigilance and adaptability in the face of ever-changing economic challenges. Therefore, the RBI's efforts in managing inflation represent a harmonious blend of tradition and innovation, anchoring India's economic path towards prosperity and resilience.

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