Thread by @FinsenseG

What does the Monetary Policy Committee and what does it do?

What is inflation and how do money supply and interest rates affect it?

Why does the stock market react to policy announcements the way it does?

A thread 🧵👇

1/ Monetary Policy refers to the actions taken by the RBI to control economic indicators like inflation through the management of money supply and interest rates.

2/ Repo rate is the interest rate at which the banks can borrow money from the RBI. The reverse repo rate is the rate at which the banks can park their money with the RBI and earn interest on the money.

3/ RBI Monetary Policy Committee examines the inflation and growth situation in the country and decides whether to cut or increase the interest rates.

4/ The committee consists of 6 members, 3 from the RBI and 3 appointed by the government. They debate about what decision is supposed to be taken and each gets a vote. In case of a draw, the RBI Governor gives the deciding vote.

5/ Before MPC was formed in 2016, RBI had to juggle and balance multiple indicators like employment, inflation, growth, and the need for a fairly stable currency.

6/ On one side, there were consumers who were facing high inflation and on the other side was the government, wanting to lower interest rates further to spur the economic growth and borrow at cheaper rates.

7/ Needless to say, it was a very difficult task to strike a balance between everything mentioned above. So in 2016, the Monetary Policy Committee was formed whose main objective was inflation targeting.

8/ Currently, the mandate for the RBI is to manage inflation in the range of 4% with an upper band of 6% and a lower band of 2%.

What this means is that RBI has to take its policy decisions to ensure that inflation does not rise more than 6% and does not fall below 2%.

9/ RBI also tries to raise funds for the government at the cheapest possible interest rates. The government too has to be prudent with its fiscal deficit (spending more than you earn) and hence, coordination between Government and RBI is needed.

10/ Terms to look out for, around MPC and its decisions:

Accommodative Stance :- It means that the MPC is open to further rate cuts and an increase in the money supply to stimulate growth in the economy.

11/ Dovish Stance - It is similar to accommodative, aiming at making credit cheaper and inducing people to spend to stimulate economic growth.

Neutral Stance - It indicates that the RBI can cut rates in either direction so as to manage the money supply and inflation.

12/ Hawkish Stance - It is the opposite of Dovish stance, it indicates that MPC is closely looking at the inflation, controlling which is its main priority. Hence in the future, rates might be increased.

13/ Inflation - It means the rise in the price of goods or services.

14/ How does inflation cause the rise in price or services and when does it happen?

When demand exceeds the supply or in other words when demand in the economy exceeds the total output of the economy. It happens, when there is a lot of money floating around (money supply).

15/ Suppose you wanted to buy a smartphone worth ₹15,000 but could not save enough. One day our government announces that it will print the currency and every citizen of India will be getting ₹15000.

16/ Now, you have the money to buy the smartphone, but so do others. So, now, 10 lakh people are demanding the same smartphone. But there is a problem, the mobile company can produce only 5 lakh mobiles per year. Clearly, the demand has exceeded the supply.

17/ So, what will happen next?

The price of the smartphone is raised to ₹20,000 and so demand falls to 5 lakh smartphones. This increase in price is called inflation.

18/ Inflation can also be caused due to supply-side disruption like floods destroying crops which makes the supply scarce and causes the price to rise.

19/ How does RBI control money supply ?

Other than printing currency notes, RBI increases the money supply by buying government securities from banks and investors. Thereby, transferring the money from RBI into the economy.

20/ When RBI wants to reduce the money supply, RBI will sells these securities to banks and investors, thereby taking away the money from the economy.

21/ How is interest rate related to all this?

Suppose the RBI Monetary Policy Committee decides to cut the repo rate from 5% to 4%. So, the banks can borrow at 4% from the RBI & advance that money to the borrowers. Bank has to pay less, so it charges less now from the customer.

22/ Before the repo rate cut, the EMI cost you ₹2700/per month which you felt was expensive. But after the rate cut, the monthly EMI cost drops to ₹2500/per month which means now it is your budget and you can go ahead and buy the smartphone.

23/ Similarly, others would also go ahead and buy the smartphone causing the demand to exceed the supply, hence, causing a rise in the price of smartphones and which leads to inflation.

24/ Lower interest rates discourage people to save (because they would get less interest on their saved money) and encourage them to spend more. So when economic activity is down, RBI can reduce interest or increase the money supply to stimulate demand like in the above examples.

25/ AND when the inflation rises, it can increase interest rates or decrease the money supply in the economy, discouraging the people to spend and save more (because now they would be getting more interest on their savings, and also their EMIs would get costlier).

26/ Do rate cuts reach the bottom of the economy ?

The answer to this question might not be straight. When repo rates are cut in a bad economic environment, banks could borrow at lower interest rates for a short duration, but they lend that money for a longer duration.

27/ Hence, during bad times they would actually not lend at all or keep the interest rates unchanged due to their fear of increased risk. Rather, banks would park their funds with RBI and not lend. This would render the rate cuts ineffective to some extent.

28/ To tackle this, RBI initiated Targeted Long term repo operation (TLTRO)- lending of money to banks at the repo rate for a longer duration of 3 yrs. It also reduced the regulatory amount banks have to keep aside, thereby increasing the disposable amount that the bank can lend.

29/ AND when banks have too much money, RBI would not pay them much (reverse repo rate), they would have to lend to earn money and recoup the interest they are paying to their depositors. Thereby, increasing the money supply, increasing spends, and stimulating growth.

30/ All this is okay, but why do stock markets rise and fall based on the MPC decisions?

To work efficiently, stock markets need liquidity. When RBI cuts the repo rate and increases the money supply, markets get more money, loans get cheaper, people spend more

31/ AND because people look for higher returns compared to little interest they are earning on their savings, people divert that money towards riskier assets like equity. The opposite happens when interest rates are increased.

32/ Why do markets fall on rate cuts ?

The other way to look at this scenario would be that when RBI cuts interest rates, it somewhat expects the economic activity in the country to drop, some investors might take this as a negative indicator and sell their equity exposure.

33/ Currently, RBI has an accommodative stance to support growth after the disruption caused due to Covid-19, though it also has a sharp eye on the rising inflation rate which is currently at the upper band of 6%, possibly caused by supply side disruption.

BY :- @sneh_kagrana