November 13, 2018 CFA Level 1Admin

Monetary Policy Decoded – CFA® Program Level I

What is ‘Monetary Policy?’

Monetary policy consists of the actions of a central bank, currency board or another regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as modifying the interest rate, buying or selling government bonds, and changing the amount of currency banks are required to keep in the vault (bank reserves).

Monetary policy is an integral part of the economic development strategy in any economy due to its significant impact on economic sustainability. It has been an effective tool for regulating the economy through several tools. Nowadays the use of monetary policy tools to manage economic growth processes is a common practice in all market economies by balancing money supply and demand in domestic markets, increasing the benefits from foreign trade by exchange rate and overall financial flows by monitoring inflation rate trends. However, most effective tools are refinancing rate, mandatory reserve requirements and sterilization operations, which have direct linkages to financial flows, money supply, inflation, and exchange rate.

U.S. Federal Reserve

Most central banks are independent of other policymakers. This is the case with the Federal Reserve and Congress, reflecting the separation of monetary policy from fiscal policy. The latter refers to taxes and government borrowing and spending.

The Federal Reserve has what is commonly referred to as a “dual mandate”: to achieve maximum employment (in practice, around 5% unemployment) and stable prices (2-3% inflation). In addition, it aims to keep long-term interest rates relatively low, and since 2009 has served as a bank regulator. Its core role is to be the lender of last resort, providing banks with liquidity in order to prevent the bank failures and or panics in the financial services sector.

The Effectiveness of Monetary Policy

According to the Keynesians, monetary policy is ineffective and less reliable because of the following reasons. Monetary policy is only among many factors that determine the level of nominal national income in the short-run. Changes in the money supply may lead to opposite changes in velocity and thereby limit the effectiveness of the monetary policy.

Finally, during the recession, investment is unresponsive to interest rate changes. Keynesians believe that the economy operates under liquidity trap range (horizontal LM curve). The IS curve is vertical or interest inelastic. It is a depressed economy in which prices, income level, the rate of interest and velocity of money are very low and speculative demand for money is very high. In such a situation, monetary policy is ineffective. An increase in the money supply does not shift the LM Curve and therefore, there will be no change in the income level and interest rate.

The Monetarists consider the monetary policy to be effective at least in the short period. They have produced empirical evidence to show that changes in nominal national income, employment and the price level are more closely related to changes in the money stock than to changes in Government expenditures and taxes.

Monetary Policy and Price Stability

The RBI is now more capable and more responsible for controlling the overall growth of money and credit in a manner best suited for moderating inflation while meeting the genuine credit needs of the economy. Its capacity for effective money management or any inflation control needs to be further strengthened through rapid deepening and broadening of primary and secondary markets for Government securities.

With greater autonomy comes more responsibility. The role of monetary policy has too long been a passive one, confined to financing the fiscal deficit at administered interest rates in order to minimize the cost to the Government. This has in the past encouraged fiscal profligacy with growing fiscal deficits, and larger and larger components of monetization which in turn has generated inflationary pressure and has distorted the financial system raising interest rates to the productive sector. It was necessary to make a decisive break from this pattern.

With the reduction in the fiscal deficit, the Government was working towards a situation where interest rate distortions were reduced and monetary policy could be actively used for short-term macroeconomic management. The Government has progressed towards this aim in the past years with a number of initiatives. The statutory liquidity ratio has been reduced, releasing resources to the banks for deploying additional funds in the commercial sector. Government borrowing was also being shifted to market-related rates; the 364-day bills were introduced with market-related interest rates. Other interest rates on securities were raised to bring them closer to market rates. Reserve Bank of India also conducted repurchase operations in securities for short-term liquidity management.

Monetary Policy Instruments:

Monetary policy is a way for the RBI to control the supply of money in the economy. So these credit policies help control the inflation and in turn help with the economic growth and development of the country. So now let us take a look at the various instruments of monetary policy that the RBI has at its disposal.

  • Open Market Operations:

Open Market Operations is when the RBI involves itself directly and buys or sells short-term securities in the open market. This is a direct and effective way to increase or decrease the supply of money in the market. It also has a direct effect on the ongoing rate of interest in the market.

Let us say the market is in equilibrium. Then the RBI decides to sell short-term securities in the market. The supply of money in the market will reduce. And subsequently, the demand for credit facilities would increase. And so correspondingly the rate of interest would also see a boost.

On the other hand, if RBI was purchasing securities from the open market it would have the opposite effect. The supply of money to the market would increase. And so, in turn, the rate of interest would go down since the demand for credit would fall.

  • Bank Rate

One of the most effective instruments of monetary policy is the bank rate. A bank rate is essentially the rate at which the RBI lends money to commercial banks without any security or collateral. It is also the standard rate at which the RBI will buy or discount bills of exchange and other such commercial instruments.

So now if the RBI were to increase the bank rate, the commercial banks would also have to increase their lending rates. And this will help control the supply of money in the market. And the reverse will obviously increase the supply of money in the market.

  • Variable Reserve Requirement

There are two components to this instrument of monetary policy, namely – The Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR). Let us understand them both.

Cash Reserve Ratio (CRR) is the portion of deposits with the commercial banks that it has to deposit to the RBI. So CRR is the per cent of deposits the commercial banks have to keep with the RBI. The RBI will adjust the said percentage to control the supply of money available with the bank. And accordingly, the loans given by the bank will either become cheaper or more expensive. The CRR is a great tool to control inflation.

The Statutory Liquidity Ratio (SLR) is the per cent of total deposits that the commercial banks have to keep with themselves in form of cash reserves or gold. So increasing the SLR will mean the banks have fewer funds to give as loans thus controlling the supply of money in the economy. And the opposite is true as well.

  • Liquidity Adjustment Facility

The Liquidity Adjustment Facility (LAF) is an indirect instrument for monetary control. It controls the flow of money through repo rates and reverse-repo rates. The repo rate is actually the rate at which commercial banks and other institutes obtain short-term loans from the Central Bank.

And the reverse repo rate is the rate at which the RBI parks its funds with the commercial banks for short time periods. So the RBI constantly changes these rates to control the flow of money in the market according to the economic situations.

  • Moral Suasion

This is an informal method of monetary control. The RBI is the Central Bank of the country and thus enjoys a supervisory position in the banking system. If there is a need it can urge the banks to exercise credit control at times to maintain the balance of funds in the market. This method is actually quite effective since banks tend to follow the policies set by the RBI.

Monetary policy 2018-19:

RBI Monetary policy June 2018:1st Repo rate hike in Modi’s 4-year era

Urjit Patel-headed six-member Monetary Policy Committee of the Reserve Bank of India in its first three-day bi-monthly policy meeting raised the key repo rate by 25 basis points for the first time since January 2014, in about four-and-a-half years, to 6.25%. “The decision of the MPC is consistent with the ‘neutral’ stance of monetary policy in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4% within a band of +/- 2% while supporting growth,” RBI said in a statement.

RBI Monetary Policy August 2018: 2nd rate hike in Modi era

HIGHLIGHTS from RBI’s 3rd MPC — August 2018 FY19

Monetary and Economic Backdrop

  • Repo rate under the liquidity adjustment facility (LAF) has been raised by 25 basis points to 6.50%.
  • Reverse repo rate under the LAF stands adjusted to 6.25% and the marginal standing facility (MSF) rate and the Bank Rate has been adjusted to 6.75%.
  • The MPC Committee has decided to retain the projection of GDP growth for the financial year 2018-2019 at 7.4% and 7.5% for Q1 FY20.
  • MPC Committee maintained a neutral stance of monetary policy in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4% within a band of +/- 2 % while supporting growth.

RBI Monetary Policy October 2018: Surprise, surprise! RBI keeps the repo rate unchanged at 6.5%

The Reserve Bank of India (RBI) today kept the repo rate unchanged at 6.5%, spooking the market, which had widely expected a rate hike of 25 basis points. While the RBI decided to maintain the status quo, it turned hawkish and ruled out any rate cut in future by changing stance from ‘Neutral’ to ‘Calibrated Tightening’.

From the past four Bi-monthly Monetary Policy meetings we observed that RBI is changing the policy rates with the objective of achieving the medium-term target for CPI inflation of 4%. So, let’s see what the relationship between Repo Rate and Inflation is:

What is Repo Rate?

The rate at which the RBI lends money to commercial banks is called repo rate. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI. A reduction in the repo rate helps banks get money at a cheaper rate and vice versa.

When repo rate increases

  • Banks lend from RBI at a higher rate of interest
  • They lend it to borrowers at a high rate of interest
  • . As lending interest rate increases, borrowing of money decreases
  • . Increase in the deposit interest rate to attract depositors

When the repo rate decreases

  • Increase in money supply in the economy
  • Increase in demand for goods
  • Increase in GDP growth

Effects of Repo rate on Inflation:

When the repo rate is raised, banks are compelled to pay higher interest to the RBI which in turn prompts them to raise the interest rates on loans they offer to customers. The customers then are dissuaded in taking credit from banks, leading to a shortage of money in the economy and less liquidity. So, while on the one hand, inflation is under controlled as there is less money to spend, growth suffers as companies avoid taking loans at high rates, leading to a shortfall in production and expansion. For instance, if the availability of funds is scarce, and banks are not able to borrow at repo rate, they may have to increase the deposits rates upwards to attract depositors. Hence, any rate hike in repo rate increases the probability of higher deposit rates, which is good news for depositors.

Impact on Sectors

Sectors such as automobiles, consumer durables and realty are the most vulnerable in the scenario where policy rate hikes push the interest rates. Rising rates would not only reduce the demand for these companies’ products, but they will also affect their earnings in terms of rising interest costs. Rising rates would also impact companies with higher leverage. Besides, there is a possibility that more money gets allocated to debt than equities given the risk-return tradeoffs.

What is the Reverse Repo Rate?

Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money is in safe hands with a good interest. An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system.

Reverse Repo rate effect on inflation

If RBI increases this Reverse Repo rate, it means RBI wants to contraction of credit. When RBI gets the loan from banks at high rate of interest, more and more banks will supply to central bank because it is safe and earning is more. Effect of this will on the financial market. Supply of money in financial market will decrease. Due to a decrease in the supply of credit in the market, the inflation rate will decrease.

CFA Program curriculum teaches you such concepts, and more, with adequate depth for a student to become a complete professional.

FINSTUDYCLUB, widely known a FSC, brings together the very best resources in CFA® program online classes – world class trainers in Amit Parakh, CFA and Ankur Kulshrestha, CFA® plus the CFA® Program prep material by WILEY and online collateral. With a guided approach for CFA® program training through tailor-made online course packages, your chances are certainly better!