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The impact of tight monetary policy

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The RBI in its off-cycle meeting held last week revised upwards the policy rates to manage increasing inflationary pressures. Mint examines its impact on the economy and the common man:

The Reserve Bank of India (RBI) in its off-cycle meeting held last week revised upwards the policy rates to manage increasing inflationary pressures. Mint examines its impact on the economy and the common man:

What decisions were taken at the meeting?

The  Monetary Policy Committee (MPC) decided to hike the policy repo rate under the liquidity adjustment facility by 40 basis points (bps) to 4.40%, while remaining ‘accommodative’ in its approach to balancing of growth levels and rising inflationary pressures. This came against the backdrop of the current and evolving macroeconomic scenario. The repo rate is the rate at which RBI lends money to commercial banks. It also increased the cash reserve ratio (CRR) by 50bps to 4.5%. The CRR is percentage of net demand and time liabilities that banks need to park with the central bank.

What could be the impact of the hike?

Interest rates charged on loans will witness an increase, which in turn would push up production costs. This could in turn adversely impact consumption demand at a time when demand constraint has been a major hurdle in the revival of the economy. By raising the CRR by 50bps, RBI is siphoning off 87,000 crore from the banking system, thus reducing liquidity levels in the economy. While this will have a positive impact and help tame inflation, it could also exert further pressure on interest rates. The good news, however, is that with commercial banks raising interest rates it would work in favour of depositors.

Policy action
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Policy action

What influenced the change in the central bank’s policy?

The Consumer Price Index-based inflation was the highest in 17 months in March at 6.95%. Besides, since the last MPC meeting in April, inflationary pressures because of external factors such as oil and commodity prices, and supply chain disruptions because of geopolitical tensions, have persisted. This has heightened the uncertainty around inflation.

Is the MPC right in its policy track?

Going by inflation-targeting approach per se, the MPC has taken the right decision. With rising prices and also broad-based second round price pressures, raising policy rates is recommended. But with consumption remaining subdued, this may be counter-productive and might lead to growth stagnation. Qualitative analysis shows that the inflationary trend is primarily cost-push and cannot be contained via monetary tools. The government should also put in place fiscal policy measures that can reduce supply bottlenecks.

What is in store for the common man?

Consumer loans and, consequently, EMIs are set to become costlier. It could lead to demand for consumer durables and housing being discouraged. This will have an adverse impact on the economy in terms of employment opportunities. Those who have taken loans on floating rates are in for a shock. However, on the flip side, increased policy rates will cheer depositors as it would lead to higher interest on fixed deposits.

Jagadish Shettigar and Pooja Misra are faculty members at BIMTECH.

 

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