Tag Archives: Inflation

Understanding the impact of RBI’s Repo and Reverse Repo Rate Cut

It has happened as expected. RBI has announced a 25 basis point cut in the Repo and Reverse Repo rates. For the less exposed, this means that the Repo Rate has fallen from 7.75% to 7.5% while Reverse Repo Rate has fallen from 6.75% to 6.5%. What does this mean to different people? The segments we cover in this article are Banks, Industry, ordinary people and the broader economy.

Impact on Banks

To understand the impact of a cut in Repo and Reverse Repo Rates on banks, it is important to understand the role they play in banking. Repo and Reverse Repo are basically instruments used by the RBI to influence the total monetary base of banks.

To get a grip on this, it is important to understand how banks work and what the term monetary base means. Banks engage in a practice called Fractional Reserve Banking (FRB). As explained in the linked article, under FRB, a bank lends many multiples of the actual cash in hand. This cash they have is what I mean by monetary base. Clearly, any addition to the monetary base adds to the bank’s ability to make loans by creating money from nothing (as explained in the linked article).

In India, banks’ monetary base takes 2 forms – CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio). CRR is the amount of actual cash that banks need to hold with the RBI. SLR refers to the amount (by value) of approved securities (government bonds, gold and approved, privately issued financial instruments) that banks are mandated to hold. Currently, CRR is 4% and SLR is 23%. Together, they constitute the monetary base of the Indian banking system.

However, what CRR and SLR do not cover is the extent to which the RBI can lend to banks. That is covered under the Repo and Reverse Repo. In a Repo or a repurchase agreement, the Repo seller (the bank) sells an approved security to the RBI with the understanding that at a certain date in the future, the bank will buy the security back from the RBI. The bank gets cash and the RBI the security.

One would expect that this would not influence the monetary base because while the bank gets cash and adds to its CRR base, it loses possession of the security and falls behind on its SLR base and can therefore not lend more. The interesting part is that this problem in the way of expanding bank lending is eliminated by the way the Repo system works.

Very interestingly, during the term of the Repo, the bank is allowed to count the security thus sold to the RBI as part of its investments to fulfil the SLR requirement. So, the net effect of a Repo transaction is an addition to the bank’s cash reserves without falling behind on SLR requirements. With this, the bank can now engage in much more lending.

At the end of the term of a Repo, the bank buys the security back from the RBI at a price higher than the original sale price. The difference expressed as a percentage of the original sale price is the Repo Rate. Thus, Repo Rate is used to calculate the price at which the security is bought back by the bank. It is the equivalent of an interest paid by the bank to RBI.

It might seem that at the time the bank buys the security back, its cash reserve falls. However, the bank can then enter into a fresh Repo transaction and sell the security back to the RBI, bringing the cash reserve back to the higher level. In this manner, Repo becomes a means for the RBI to maintain a steady level of lending to banks.

But all this additional lending would mean more purchases of securities to meet SLR requirements. This would mean the need to deploy cash for the same. That cash would go outside the system of lending and reduce the system’s lending potential. This problem is solved by what is called the Reverse Repo.

In a Reverse Repo, the RBI sells an approved security to the bank with the understanding that it will buy it back at a future date at a higher price. The difference between the 2 prices expressed as a percentage of the original selling price (per annum) is called the Reverse Repo Rate. The Reverse Repo Rate thus becomes the interest rate received by the bank for lending cash to the RBI.

The important point for us to note is that a bank may show securities bought from the RBI through the Reverse Repo window as part of its SLR commitments. Further, as in the case of the Repo, at the end of the term of the Reverse Repo, the bank can enter into a fresh Reverse Repo with the RBI.

Summarising the understanding

Bank XYZ hits its lending limit based on its CRR and SLR. It sees potential for more lending. It offers RBI a portion of the securities it holds as part of a Repo transaction and gets cash. It deploys 23% of this new cash to obtain securities under the Reverse Repo window from the RBI, thus keeping the cash within the system. The bank now gets to create new money amounting to 1/(CRR+SLR) times the money borrowed under the Repo window and lend it out at interest. The Repo window thus becomes a cheap source of borrowing for banks.

The impact of a cut in Repo and Reverse Repo Rates

A cut in Repo and Reverse Repo rates basically reduces the bank’s cost of borrowing from the RBI to add to its reserves. It enables banks to either increase the interest rate spread on loans made by the bank or offer borrowers lower rates of interest without eating into its own interest rate spread. Thus, a cut in Repo and Reverse Repo Rates increases the banking system’s potential by expanding more loans in a profitable manner.

Impact on Industry

With lower repo and reverse repo rates, industry gets to borrow more and even gets to pay lower interest rates on its borrowing. Therefore, those businesses that are in a position to secure additional lending from the banking system will benefit from lower repo and reverse repo rates.

Impact on ordinary people

The impact on ordinary people can be felt in 2 ways. In the nearer term, greater lending to businesses will lead to more business investment and employment opportunities. In the medium and longer term, however, the dominant factor influencing ordinary people will be the increased money supply (inflation), which will send prices of consumers’ goods soaring, resulting in future pressure to raise interest rates thus forcing the pricking of the inflationary bubble and the onset of the depression.

Impact on the broader economy

In the long-run, reducing Repo and Reverse Repo rates is harmful for the economy as it is just a means to lend reserves to banks, enabling them to engage in far bigger inflation to undertake much more credit expansion through FRB. While this lending will have some short-term positive effects, in the long-run, it creates and worsens the inflationary boom of the familiar boom-bust cycle. It also sets the conditions for the inevitable raising of interest rates thus pricking the inflationary bubble and triggering the depression.

Conclusion

Thus we see that the policy of reducing Repo and Reverse Repo rates is essentially bad for the economy in the long-run because it greatly aids the creation of the business cycle. It also hurts ordinary people by sending prices soaring. Industry and the banking system, however, benefit in the short run. This explains why a policy of lowering repo and reverse repo rates finds fairly broad-based support from the banking industry and general industry as well.

The hidden side of RBI’s push for more electronic payments

In this article, the RBI is cited to be pushing for electronic payments as a replacement for cheques for loan repayments. The obvious explanation is that ECS will eliminate all the time and effort involved in collecting, depositing cheques and then getting them cleared. This is supposed to leave the banking system more efficient.

What is not stated is the deeper reason for the move – to make people more accustomed to making electronic payments for everything to eventually make the move to eliminating cash.

Now, cash is a bothersome thing. As long as people have a concept of cash and want it for various purposes, the banking system has to keep some cash. This is the reasoning behind having reserve ratios like CRR and SLR. With these, the bank is supposedly in a position to comfortably meet demand for cash.

Why does people having a demand for cash make it bothersome?

If people did not have a demand for cash, there is no operational limit to how much money the central bank and the entire banking system can create. We will then land in Inflationist Utopia where money creation and credit expansion can go on unbridled. That also means that all limits on government spending are eliminated.

Is it possible that this Inflationist Utopia is RBI’s goal?

Is MNREGS a significant cause of rapidly rising prices?

The Financial Express reports thus – ‘Rural wage hike pushing inflation, posing challenge for RBI’. It goes on to quote an Assocham spokesperson thus.

“Near 20 per cent annual increase in the wage inflation in rural areas is building up price pressures on food articles like cereals, rice and wheat, and is posing a big challenge for the Reserve Bank which is being called upon to cut the policy interest rates on Tuesday,” industry body Assocham said.

So what sense are we to make of this? Why would rural wages shoot through the roof in this manner? As far as I understand, there are two possible reasons. The first is that agriculture has seen such a tremendous productivity increase that marginal value product of a unit of labour has really gone up 20%. Alternately, as I explained out here, a steady rise in prices is possible only if inflationary policies greatly and steadily increase money supply.

And over the last couple of years, the Government of India, through various State governments, has really been flooding the rural markets with money through the MNREGS. So should we be surprised that rural wages have increased as much and as rapidly as they have? If we are, then it is time to revise our economics fundamentals. That such an outcome is inevitable could have been known right at the time of conceiving of a scheme like MNREGS. Why then are such policies being pushed? These and many other such tough questions are what we should be asking policy makers, but only an economically literate population can do so.

Cantillon Effects and the “strange” divergence between CPI and WPI

This article focuses on a certain divergence between two popularly used measures of price inflation – WPI and CPI – to explain the limited room available to the RBI in cutting interest rates as demanded by many sections of industry. My article seeks to explain that such a divergence is not unusual and in fact normal in an economy driven as much by credit injection through monetary inflation as the economy of today is.

In economic theory, the term Cantillon Effects refers to the asymmetric distortionary effect of inflation (defined in the Classical tradition as an increase in the money supply) on the prices of goods. In simple terms, an increase in money supply does not lead to a uniform rise in the prices of all goods and services. Some prices rise more while some others may rise less, stay stable or even fall in the face of inflation.

Why would there be Cantillon Effects of inflation?

The important point is that money always and everywhere exchanges for particular goods and not for all goods, definitely not for a basket of goods like the ones for WPI and CPI calculations. A good way to understand this is to imagine for a moment that the good Angel Gabriel decides to double the money stock of some good people (while they are asleep) in a certain society. The next morning, this economy sure has greater money supply but the additional money supply is in the hands of particular individuals only.

The additional stock of money immediately influences the value scales of the particular individuals alone to begin with. The marginal unit of money becomes less valued to these people and therefore a certain number of units of particular goods that were earlier considered less valuable than the marginal unit of money may suddenly appear more valuable than the marginal unit of money. So, these people step out and buy these goods. In economic terms, the demand schedules of these buyers have been influenced and their demand curves have been shifted rightward. The demand curves for the particular goods see a rightward shift as well.

However, the value scales of suppliers of these goods do not see any change as nothing has changed for the suppliers. This results in an unchanged supply curve, which, in conjunction with a rightward shifted demand curve, will lead to a higher equilibrium price for the particular goods that these people buy.

In the meantime, demand and supply schedules of other goods remain unaffected and their prices remain unaffected as well. Thus, we see that injecting money into the hands of particular people can raise the prices of some goods while having no influence whatsoever on the prices of other goods. This phenomenon is what we understand in Economics as Cantillon Effects.

The “strange” divergence between WPI and CPI

Let us first remind ourselves that we are right now at the end-stage of a previous round of inflation created by an out-of-control fractional reserve banking system. During any such inflationary period, there will be Cantillon Effects of the inflation. In the early stages of such an inflation, the money injected by the banking system into the production structure will necessarily be spent first on buying factors of production including capital goods, land and labour. This spending works its way through the system of production till it lands in the hands of the owners of land, labour and capital as rent, wages and interest respectively.

Therefore, the immediate effect of the initial inflation is necessarily to raise the prices of producers’ goods, which in turn will cause an index like the WPI to rise while leaving the prices of consumers’ goods relatively unchanged, thus leaving an index like CPI relatively unchanged as well. It is only in the late stages of the inflationary process when the land and labour factor owners and capitalists spend their income on consumers’ goods that their prices and hence CPI go up. At that stage, we may very well witness a rise in CPI being accompanied by a much smaller rise in WPI.

The kind of move that the article cited above speaks of is therefore nothing unusual and is in fact to be expected in an economy driven by inflationary credit expansion by a fractional reserve banking system.

Policy implications

Actually, there are few or no policy implications. Any attempt by the RBI to push money supply up by dropping rates is likely to lead to greater credit expansion through inflationary banking or money injection into the system of production. Therefore, the first effects are once again likely to be on the prices of producers’ goods, i.e., on the WPI. It is only in the future that the effect on consumers’ goods prices will become visible and the CPI goes up again.

Unless the banking system is completely broken and has no avenues into which credit can be injected, it is certainly possible for the banking system to inject newly created money into the production system. There is therefore little to fear and no reason to argue that the RBI has little headroom in tinkering with interest rates, especially once it has, as has every central bank, chosen the path of inflationary banking.

Fixing Inflation

This article raises an issue very relevant to the times we live in – fixing inflation. Summarising what Mr. Subbarao says, inflation is a supply side problem. That means that according to him, inability of the system of production to keep up with the ever-rising demand for goods and services is responsible for steadily rising prices. This inability, he implies, is due to fiscal policy failures and a slow pace of reform dragging economic growth down. The responsibility for fixing the problem, as per Mr. Subbarao, lies with the government. In his opinion, there is precious little that the RBI can do to stimulate growth without stoking the fires of inflation.

Mr. Chidambaram, on the other hand, believes that he has done what he could and was expected to do, i.e., keep fiscal deficit under control, to keep inflation under control, and that the ball is now in the RBI’s court. He believes it is time for the RBI to cut interest rates and tinker with other parameters in its control (like CRR and SLR) to boost growth.

What do we, as ordinary people, make of this debate happening in rarefied environs? Let me make a beginning by focusing, in this article, on inflation.

What is inflation?

The commonly accepted definition of inflation is the steady rise in prices, which is measured through price indices like WPI and CPI. The Classical (Original) definition of inflation, however, is the increase in money supply. This might come as a surprise to many of you because all you may have heard is the commonly accepted definition given above. So here, here, here and here are some links that confirm what I am saying.

Which of these is meaningful and useful?

Only the Classical definition of inflation is meaningful and helps us understand real world phenomena like ever-rising prices while the commonly accepted definition is utterly useless.

Why is the Classical definition meaningful and useful?

Money is a commodity like any other. It has a price too. That price is determined, like it is for all other commodities, by the forces of supply and demand. When money supply increases, the price of money falls. When the price of money falls, the prices of goods and services denominated in that money rise. A steady rise in the supply of money causes a steady rise in prices. Thus, the Classical definition of inflation helps us understand the real world phenomenon of rising prices from fundamentals and is therefore meaningful.

Why is the commonly accepted definition of inflation useless?

Defining inflation as the steady rise in prices tells us nothing about what caused prices to rise in the first place. Explanations like the demand-pull and cost-push theories, and structural/built-in inflation are based on elementary economic fallacies and errors. For instance, if we say that prices are rising because demand is rising, what caused the demand to rise in the first place? If we say prices rise because costs rise, aren’t costs prices themselves? Are we then not bound to explain what caused THOSE prices to rise first? If we do not, would we not be guilty of engaging in circular reasoning by saying that rising prices cause prices to rise? And is saying that some price rise is “built-in” not a negation of economic theory itself, especially price theory, which seeks to explain prices from fundamentals?

A small point of caution while using the Classical definition of Inflation

It often happens that productivity improvements send supply of goods and services up so rapidly that we do not see rising prices but stable or even mildly falling prices. In such cases, it is important to bear in mind that in the absence of inflation, prices of these goods and services would have been much lower than they currently are. So, merely observing stable, slowly rising or mildly falling prices in the face of increase in money supply does not negate the Classical definition of inflation.

What causes money supply to increase steadily?

As explained in my previous post, the banking system that we live with is the fundamental and most proximate cause of inflation. Fractional Reserve Banking is based on creating money many multiples of the monetary base we start with. A banking system with a 10% reserve ratio can multiply every Re. 1 into Rs. 10. The Rs. 9 is addition of money supply by the banking system.

Central Banks (like RBI) make matters worse. They have reserve ratios of their own based on which they lend reserves to banks. The US Fed, for instance, has a reserve ratio of 35%. This means that the Fed multiplies the banking system’s monetary base by 1/0.35 or 2.9 times. Combined with the banking system’s reserve ratio, every $1 can be multiplied into $29. The inflationary potential of the banking system is thus magnified by Central Banks.

Government spending draws resources from the private sector through taxation and borrowing. All this leads to a pressure to keep increasing money supply.

It is these 3 factors – the Banking System, Central Banks and Government – that are responsible for causing inflation (as per the Classical definition).

What does this help us do?

At the very least, it helps us pin the blame for the phenomenon of ever-rising prices. At a deeper level, it gives a solution to the problem. All it takes to solve the problem of inflation is for the triumvirate identified above to stop engaging in inflation (as per the Classical definition).

The question is, would they? And if they would not, why is it so? These are important questions that we will find answers to in subsequent posts.