RBI’s role in policy rates and inflation!

RBI raised the policy rates by 25/50 basis points. This is the most familiar statement in media for last couple of months. The role of RBI seems to have increased recently since India started experiencing major inflationary pressure on her economy.

What exactly RBI intends to achieve by raising policy rates, also known as repo and reverse repo rate. We will make some sense of these moves by RBI and discuss the implication of it.

Monetary function

One of the functions of RBI is monetary policy structuring and implementation. The core focus of monetary policy is to increase or reduce the money supply in the market. The only way to do it is to increase or reduce the repo and reverse repo rate. Repo rate is the rate at which banks borrow money from RBI and reverse repo is the rate at which RBI borrows money from the bank.

Now what does RBI intend to achieve by changing these rates. Let’s look at how increasing and reducing the repo and reverse repo rates affect the market. If the policy rates are higher, the cost of money for banks is high. This means that the banks will charge higher interest rate for loans. The banks will also provide high rates to depositors.

If the depositors get good rates, this will encourage people to deposit money in banks. People will prefer saving because of the good returns that banks promise. This will reduce money in the market thus impacting consumption.

Similarly, when the banks start charging high rates for lending, this will discourage people from borrowing. People will postpone their purchases of home, vehicles, and other items because of high lending rates on their home loans, personal loans and car loans. This will again reduce money supply thus impacting consumption.

RBI’s objective vis-à-vis policy rate

RBI intends to do the same thing by increasing the repo and reverse repo rates. The money supply will be reduced and hence consumption will go down. If the consumption goes down, producers will reduce the price of goods to attract buyers to increase consumption. This will reduce the overall prices of commodities and other goods.

Since India is facing high inflation for last couple of years, RBI’s chief objective is to reduce the inflation by reducing money supply in the market. This explains why RBI increased the policy rates 11 times since early days of 2010. Price stability has become the main objective for RBI.

Growth versus Inflation debate

The unhindered increase in policy rates has resulted in reduced growth projection of the Indian economy. As consumption goes down, producers do not see much incentive in producing more. This impacts the overall gross domestic products. Hence the growth rate goes down as a consequence of RBI raising the policy rates.

Many experts have warned that the move of RBI is going to have little or no impact on inflation because inflation is caused by supply side constraints and increasing oil prices. RBI has no control over both these factors. This argument does sound credible as we still do not see ease in prices despite so many increases in the last few months.

The other school of thought says that the inflation has been at least capped and has not been allowed to go further up because of RBI’s move.

It is really difficult to say who is right as these are post facto observation. On hindsight, we can conclude whether the intended change was effected. However, when you have to plan keeping future in mind, nobody can be sure of the effect.

Finally

Slower than expected growth in developed economies has reduced commodity prices across the world. Oil has come down. This will ease the inflation in India too and take off some of the pressure from RBI. Hopefully, RBI will not have to increase the policy rates further.