What is inflation, and what is the RBI’s role in tackling it?

  • The Monetary Policy Committee (MPC) constituted by the Central Government under Section 45ZB determines the policy interest rate required to achieve the inflation target.
  • The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy. Views of key stakeholders in the economy, and analytical work of the Reserve Bank contribute to the process for arriving at the decision on the policy repo rate.
  • MPC is the body of the RBI, headed by the Governor, responsible for taking the important monetary policy decision about setting the repo rate. Repo rate is ‘the policy instrument’ in monetary policy that helps to realize the set inflation target by the RBI (at present 4%).
  • The MPC replaced the previous arrangement of Technical Advisory Committee.
  • The MPC was setup after a Memorandum of Understanding between the government and the RBI about the conduct of the new inflation targeting monetary policy framework in February 2015. 
  • Structure of the MPC 
  • The Monetary Policy Committee (MPC) is formed under the RBI with six members. Three of the members are from the RBI while the other three members are appointed by the government. 
  • Members from the RBI are the Governor who is the chairman of the MPC, a Deputy Governor and one officer of the RBI. 
  • The government members are appointed by the Centre on the recommendations of a search-cum-selection committee which is to be headed by the Cabinet Secretary.
  • The Committee is to meet at least four times a year and make public its decisions following each meeting. The quorum for the meeting of the MPC is four members. There will be no reappointment of the committee.
  • Under MPC, the governor has a casting vote and doesn’t enjoy veto power (there was veto power for him under TAC). Decisions will be taken on the basis of majority vote.
  • The main responsibility of the MPC is to administer the inflation targeting monetary policy regime through determining the policy rate or repo rate to contain inflation.
  • Function of the MPC 
  • The main responsibility of the MPC will be to keep the inflation targets set by the RBI. The MPC decides the changes to be made to the policy rate (repo rate) to contain inflation within the target (based on CPI) level set under India’s inflation targeting regime.  
  • Members of the MPC can suggest reasons for their support or opposition for a policy rate change. This will be published in the minutes of the MPC and the minutes should be published after 14 days of MPC meeting. 
  • The minutes should contain the reasons for each member proposing or opposing the monetary policy decision taken by the MPC.
  • In case the inflation target is failed to achieve (2% higher or lower than the set target of 4% for continuous three quarters), the RBI has to give an explanation to the government about the reasons, the remedial actions and the estimated time for realizing the target. Another responsibility for the RBI is to publish a Monetary Policy Report every six months, elaborating inflation forecasts and inflation sources for the next six to eighteen months.
  • How does India measure retail inflation?
  • Inflation is the rate of change in the prices of a given set of items. India bases its retail inflation metrics on the Consumer Price Index (CPI). 
  • The index records changes in prices for a sample of family budget items that are representative of what consumers typically spend their household income on — food, fuel, housing, clothing, health, education, amusement and even paan, tobacco and intoxicants. 
  • The measure is based on a weighted average. That is, some items in the index may get greater weightage depending on their priority in a typical family’s budget. The CPI-based retail inflation is measured monthly and is published as a percentage value of change in the index from the corresponding year-earlier period. 
  • Why is faster inflation a concern for policymakers?
  • Faster retail inflation is indicative of prices of household items rising quickly. While inflation affects everyone, it is often referred to as a ‘tax on the poor’ as the low-income stratum of society bears the brunt. 
  • Persistent high inflation pushes several items out of reach for this category of consumers. For example, onions and potatoes are generally a key staple in an average Indian family’s diet. But, if the price of potatoes starts rising rapidly, a poor household is often forced to sharply reduce or forgo its consumption of this key source of essential nutrients, including carbohydrates. 
  • Over time, if unchecked, persistent high inflation erodes the value of money and hurts several other segments of the population, including the elderly living off a fixed pension. It hence ends up undermining a society’s consumptive capacity, and thereby, economic growth itself.
  • What is core inflation and why is it important?
  • Core inflation helps measure inflation after excluding the effects of temporary volatility, especially from prices of items such as fuel and food. For example, seasonal spikes in food prices may skew the inflation rate, but the effect is only transitory. 
  • The RBI’s action on rates, however, affects the economy with a lag, by which time the spikes in the price of those food items may have reversed. Viewing inflation after stripping out such volatility helps give it a better picture of the underlying trend in prices.
  • What is the RBI’s role in tackling inflation?
  • The RBI’s explicit mandate is to conduct monetary policy. “The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.
  • In 2016, the Reserve Bank of India Act, 1934, was amended to provide a statutory basis for the implementation of a flexible inflation-targeting framework, where the Centre and the RBI would review and agree upon a specific inflation target every five years. 
  • Under this, 4% was set as the Consumer Price Index (CPI) inflation target for the period from August 5, 2016, to March 31, 2021, with the upper tolerance limit of 6% and the lower tolerance limit of 2%. 
  • To the extent that ensuring price stability is its primary goal, the RBI through its MPC must constantly assess not just current levels of inflation and prices of various goods and services in the economy, but also take into consideration inflation expectations both of consumers and financial markets so as to use an array of monetary tools, including interest rates, to contain inflation within its target range.
  • Instrument of Monetary policy
  • There are several direct and indirect instruments that are used for implementing monetary policy.
  1. Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
  2. Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF.
  3. Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected under fine-tuning variable rate repo auctions of range of tenors. The aim of term repo is to help develop the inter-bank term money market, which in turn can set market based benchmarks for pricing of loans and deposits, and hence improve transmission of monetary policy. The Reserve Bank also conducts variable interest rate reverse repo auctions, as necessitated under the market conditions.
  4. Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system.
  5. Corridor: The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.
  6. Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. The Bank Rate is published under Section 49 of the Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes.
  7. Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with the Reserve Bank as a share of such per cent of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of India.
  8. Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to maintain in safe and liquid assets, such as, unencumbered government securities, cash and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.
  9. Open Market Operations (OMOs): These include both, outright purchase and sale of government securities, for injection and absorption of durable liquidity, respectively.
  10. Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills. The cash so mobilised is held in a separate government account with the Reserve Bank.