With inflation in India on an upward path—wholesale price index inflation has inched close to 15% and consumer price inflation is nearly 8%—speculation is rife on whether the Reserve Bank of India (RBI) will effect another hike in its policy interest rate soon. However, the current situation begs two questions. Should there be another hike, given that RBI’s standing deposit facility (SDF) rate increase to 4.15% in May along with a repo rate hike to 4.4% counts as double tightening of monetary policy? And second, should monetary policy respond to supply shocks?
Let us first look at the SDF and why its raising constitutes a tightening of monetary policy in addition to RBI’s policy rate hike. Its current process for monetary policy formulation introduced in 2015 is called the ‘channel system’, in contrast with the ‘floor system’ of the US. In a channel system, the policy rate—the repo rate in India’s case—is bound above and below by two interest rates. The upper bound is the rate at which banks can borrow from RBI under penalty and the lower bound is the rate at which banks can park their funds with RBI for a positive rate of return. The upper bound in our case is the marginal standing facility (MSF) rate and the lower bound till recently was the reverse repo rate.
In April, RBI replaced its reverse repo rate with its SDF rate at the lower end in line with a suggestion made earlier by the Urjit Patel Committee. The central bank’s SDF rate, adjusted upward to 4.15% on 4 May, is well above the old 3.35% reverse repo rate, which gives its policy corridor symmetry and restores it to its pre-pandemic setting.
Overall, an SDF is beneficial because it does not require the collateral of government securities, while reverse repo transactions do. This will free up government securities for other collateralized borrowings, reducing the risk in such transactions significantly. In addition, an SDF brings the policy corridor’s role as a monetary policy instrument to the forefront alongside the repo rate. The MSF and SDF rates above and below the repo rate work as a carrot-and-stick incentive system for banks to manage their liquidity as optimally as possible. Other things remaining the same, an increase in the upper bound makes it costly for banks to have inadequate reserves. Similarly, a decrease in the lower bound reduces their incentive to park money with RBI and increases liquidity in the banking system, affecting other short-term interest rates as banks go in search of adequate returns on now-surplus funds.
Given this, the conclusion that the channel or corridor itself is also an effective policy tool is straightforward. Technically, if the central bank wants to tighten monetary policy, it does not have to increase its policy rate each time. It can shift the corridor up, keeping the policy rate constant, and do the opposite if it wants to loosen policy.
The reduction in the reverse repo rate to 3.35% in March 2020, which was the lower bound earlier, had constituted further loosening of monetary policy after RBI’s rate-setting panel reduced its policy rate at the onset of the pandemic. Last month, the panel upped that rate to 4.40% from 4%, even as the SDF rate was revised to 4.15% from 3.75% in April. This means monetary policy was tightened considerably in two ways, together. The two changes could have a differing immediate impact. After the panel sets a policy rate, RBI undertakes sales or purchases of government bonds to bring the weighted average of the call-money market rate in line with that policy rate. When the corridor changes, it alters the opportunity cost of funds kept with RBI. If the corridor shifts downwards, or if the lower-bound SDF rate were to decline, banks would be less inclined to keep extra funds with RBI, for that would pay too little, and would instead go in search of better returns, which ups demand for short-term securities, thus raising their prices and lowering yields. For example, after RBI reduced the lower bound of its corridor in March 2020, it not only affected rates of return on short-term government bonds but also that on commercial paper. Given the limited transmission of policy rate changes, corridor moments could arguably have better and more direct transmission.
Now for the question of responding to a supply shock. As the current rise in inflation is primarily a result of oil price escalation on account of the Ukraine-Russia war, it constitutes a supply shock. This must already have forced some expenditure adjustment on the Indian economy as rising oil prices rippled through all other prices.
If RBI raises its lending rate further, it might constitute another shock through costlier working-capital loans and short-term credit lines to firms. At least one major school of economic theory suggests that tightening monetary policy in response to a supply shock could worsen it.
A shift in fiscal policy would be a safer bet—specifically, offering price relief on petroleum products through a reduction in taxes. On this count, the government seems to have done the right thing with its recent announcement of excise duty cuts on petrol and diesel. Whether it will help tame inflation is an open question. The Centre may have some leeway here, as wholesale inflation has not translated directly into retail inflation so far. Food inflation could be addressed by the release of stocks, even as investment in cold chains for perishables can stabilize prices in the longer term and help India keep inflation in control.
Parag Waknis is associate professor of economics, School of Liberal Studies, Ambedkar University, Delhi