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De - Jargoned | Monetary policy and its implications

De - Jargoned | Monetary policy and its implications

Hopes in the financial markets are getting built around the expected rate cut in the mid-quarter review of the monetary policy on 18 June. But why are markets watching its review so closely?

What is monetary policy?

Monetary policy targets a particular level of availability and cost of money in an economy. Normally, the central bank of a country, like the Reserve Bank of India (RBI) in India and the Federal Reserve (Fed) in the US, is responsible for formulation of the monetary policy. There are stated objectives of the policy. RBI, for example, targets: “maintaining price stability and ensuring adequate flow of credit to productive sectors."

It determines the price of money in the economy, depending on the situation and assessment of the central bank, which has implications for both household and companies. Lower cost of money will mean people will borrow more, consume more and real investment in machinery will be higher. All this will push demand and growth. If an economy is witnessing high inflation, the central bank will raise the cost of money by raising rates. Higher cost of money will mean lower borrowing, lower consumption, lower real investment and softer growth.

How do central banks intervene?

There are different ways and tools by which central banks intervene in the market to achieve the stated objective. If India is witnessing high inflation, RBI will raise repo and reverse repo rates. Repo rate is the rate at which the central bank lends to commercial banks and reverse repo rate is the rate at which banks park their surplus funds with RBI. Reverse repo is pegged to repo and remains one percentage point lower than repo rate. Apart from repo and reverse repo, RBI has other tools like the cash reserve ratio (CRR); it can also do open market operations. Under CRR, commercial banks have to keep a certain percentage (currently 4.75%) of their total net demand and time liabilities with RBI. If RBI feels that there is too much money floating in the system, it will raise CRR and vice-versa. If there is temporary mismatch in demand and supply of liquidity in the system, RBI will sell bonds if it wants to take money out of the system and vice-versa.

Implications and expectations

Before cutting rates in April this year, RBI raised rates 13 times since March 2010 in order to deal with high inflation. These hikes have negatively affected profits of firms due to higher interest payment; households suffered because of higher equated monthly instalments (EMIs). With the economic growth slowing down significantly, the market is expecting rate cuts. Lower rates, other things remaining the same, will help improve profitability, enhance investments, improve growth prospects and will give you respite on your EMIs.

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