In India, the Monetary Policy Committee under RBI is majorly responsible for deciding on benchmark interest rates for the nation, along with some monetary key policies. These interest rates influence the borrowing power of both, the commercial banks and consumers, which is reflected in the inflation rates. Usually, this committee, consisting of six members, is obliged to meet 4 times a year. However, under the circumstances of COVID-19, they are required to have a meeting six times in the financial year of 2021-22 to mitigate the COVID-19 effects on the economy.
In the June meeting, the committee decided to keep the policy rates unchanged for the sixth consecutive time and concluded that they will maintain the ‘accommodative stance’ for as long as necessary. This article addresses the key takeaway from the meeting and analyses them with respect to the current economic situation.
In the meeting, it was decided that for the sixth consecutive time, the repo rate would be retained at 4% while the reverse repo rate would remain at 3.35%. To understand the effect of these policy rates on the economy, we need to consider the rates before COVID. In October 2019, the repo rate was 5.15% while the reverse repo rate was 4.90%. After the COVID-19 cases were registered in the nation and the country went into lockdown, RBI slashed both rates. By lowering the repo rate, the opportunity cost for commercial banks to borrow money from the Central bank reduced as they would now have to pay lower interest on the principal. Hence as they borrowed more money, it allowed the Central bank to induce liquidity in the economy. In addition to that, it also acted as a safeguard against bankruptcy by allowing commercial banks to have enough liquid assets to meet up the consumer demand. Further, as the reverse repo rate was also slashed, the opportunity cost for commercial banks to park their money with the Central bank increased. Now, as they would earn less interest on the principal, they would prefer to keep their assets in the economy.
Now it’s been a year since the RBI last changed these rates. In such times, maintaining constant rates serves RBI in 2 ways. Firstly, it helps in maintaining stable inflation rates. Inflation rates are directly influenced by changes in policy rates. By reducing both repo and reverse repo rates, the commercial banks are forced to induce and maintain sufficient liquidity in the economy. As the money supply increases, the inflation rate increases as well.
Moreover, it ensures a relatively stable level of inflation in the economy. For example, from the year 2021 till now, the inflation levels remained between the bracket of 4-6.5%. Keeping in mind that before the COVID crisis, the government had kept a bracket of 2-6% for inflation rates, it suggests that even after cutting policy rates, the inflation rates in the country have not increased by much and remain quite stable.
Having stable inflation is a major reason for not changing policy rates. If the rates were volatile then for entrepreneurs, it becomes really difficult to estimate the value of their investments. This would discourage them to invest in the economy and aggregate private investments would fall. Right now, economic growth is largely dependent on government expenditure. If the inflation rates start fluctuating beyond expectation, then investment, which is already quite low, would further decrease and in the worst case, would come to the brink of extinction. If that happens, the economic growth would take much greater cuts and would eventually fall into recession. Further, it would add pressure onto the government to counter such a situation by further increasing their expenditure, which would compel them to borrow money and would push them further down on the balance of payment deficit. To avoid all this, it becomes quite important for the government to ensure a stable inflation rate.
As more and are getting vaccinated and the second wave is receding, it is only a matter of time before the economy would again become completely operational. Given that the policy rates were relatively higher before the Covid crisis, one could anticipate that in coming meetings, the MPC may decide to raise them again. This would make borrowing expensive for the commercial banks, which would be reflected in higher interest rates for consumers. As investors and entrepreneurs could expect that borrowing would be soon expensive, they might start borrowing money. This would increase private investment in the economy which would in turn stimulate growth.
The efforts made to maintain inflation rate shows RBI’s commitment to salvage the economic downfall due to the second wave. However, the time has come to not just think about recovery but also think about moving on. For the remaining year, the committee has projected slight hope for the revival of the economy. With a normal monsoon, COVID adjusted workplaces, the economy is expected to grow at a rate of 9.5%. Further, with economies recovering all over the globe, trade could be expected to rise quickly in the future. Exports have been a crucial part of the Indian economy. Before the COVID crisis, exports were valued at 18.41% of the GDP in 2019. As global trade is regaining pace, demand for Indian goods would again increase. This would thus incentivize producers to increase their production capacity. Hence the employment level would increase which would consequently increase the level of consumption in the economy. This hints at the idea that maybe finally, the Indian economy could be out of the COVID scare.
However, there is still one grey area. In the second wave, rural India has also been gravely affected. Further, due to poor healthcare services there, it is still impossible to judge the gravity of Covid-19 there properly. The point to consider is that 70% of the rural population participate in agricultural activities. Hence if their health is compromised, then their efficiency would also fall down and India could in fact experience lower agricultural output, despite promising monsoon predictions. This is unlikely, yet if this happens, we could expect food inflation to hike up.
The committee’s decision to keep policy rates constant has paid in the last year as India didn’t experience unexpected levels of inflation. Moving on now, India could start looking past the COVID scare and think about rebuilding the economy. Vaccination was the first part of it and it is still far from complete. The next step in focus should be bringing production capacity closer to the economy’s potential. This could be done by reviving some old policies like Make in India along with development in technology. The prime aim should be reducing the unemployment rate.
The meeting may not have surprised anyone with drastic policy changes, however, it did hint that now, we are at the end of the tunnel and the small beam of economic revival, is getting bigger and brighter.
Hemang is a Second-year student at Ashoka University majoring in Economics and Finance.