The story so far: On May 4, the Reserve Bank of India, in a surprise move, announced that the bank’s Monetary Policy Committee (MPC) had held an ‘off-cycle’ meeting at which it had decided unanimously to raise the “policy repo rate by 40 basis points to 4.40%, with immediate effect”. Citing ‘inflation that was rising alarmingly and spreading fast’ globally, amid geopolitical tensions, RBI Governor Shaktikanta Das said that the MPC had judged that the ‘inflation outlook warranted an appropriate and timely response through resolute and calibrated steps to ensure that the second-round effects of supply side shocks on the economy were contained and long-term inflation expectations were kept firmly anchored’. Mr. Das added that the RBI’s monetary policy response would help preserve macro-financial stability amid increasing volatility in financial markets.
The repo rate is one of several direct and indirect instruments that are used by the RBI for implementing monetary policy. Specifically, the RBI defines the repo rate as the fixed interest rate at which it provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
In other words, when banks have short-term requirements for funds, they can place government securities that they hold with the central bank and borrow money against these securities at the repo rate.
Since this is the rate of interest that the RBI charges commercial banks such as State Bank of India and ICICI Bank when it lends them money, it serves as a key benchmark for the lenders to in turn price the loans they offer to their borrowers.
According to Investopedia, when government central banks repurchase securities from commercial lenders, they do so at a discounted rate that is known as the repo rate. The repo rate system allows central banks to control the money supply within economies by increasing or decreasing the availability of funds.
Besides the direct loan pricing relationship, the repo rate also functions as a monetary tool by helping to regulate the availability of liquidity or funds in the banking system. For instance, when the repo rate is decreased, banks may find an incentive to sell securities back to the government in return for cash. This increases the money supply available to the general economy. Conversely, when the repo rate is increased, lenders would end up thinking twice before borrowing from the central bank at the repo window thus, reducing the availability of money supply in the economy.
Since inflation is, in large measure, caused by more money chasing the same quantity of goods and services available in an economy, central banks tend to target regulation of money supply as a means to slow inflation.
Inflation can broadly be: mainly demand driven price gains, or a result of supply side factors that in turn push up the costs of inputs used by producers of goods and providers of services, thus spurring inflation, or most often caused by a combination of both demand and supply side pressures.
Changes to the repo rate to influence interest rates and the availability of money supply primarily work only on the demand side by making credit more expensive and savings more attractive and therefore dissuading consumption. However, they do little to address the supply side factors, be it the high price of commodities such as crude oil or metals or imported food items such as edible oils.
There is also another aspect to consider. Repo rate increases impact the real economy with a lag.
In February 2021, the RBI in its annual ‘Report on Currency and Finance’ observed that “the challenge for an efficient operating procedure [of monetary policy] is to minimise the transmission lag from changes in the policy rate to the operating target”, which in this case is the mandate to keep medium-term inflation anchored at 4%, and bound within a tolerance range of 2% to 6%.
The RBI noted in the report that there were several channels of transmission, ‘the interest rate channel; the credit or bank lending channel; the exchange rate channel operating through relative prices of tradables and non-tradables; the asset price channel impacting wealth/income accruing from holdings of financial assets; and the expectations channel encapsulating the perceptions of households and businesses on the state of the economy and its outlook’.
“These conduits of transmission intertwine and operate in conjunction and are difficult to disentangle,” the central bank added, underscoring the challenges monetary authorities face in ensuring that changes to the repo rate actually help in achieving the policy objective.