Why in news?
- The huge 50 basis points cut in rates by the U.S. Federal Reserve on 3rd March 2020, to lift economic sentiment hit by COVID-19 has disrupted central banking worldwide.
- Even as analysts debate whether a monetary policy response is the right strategy, central banks across the world are feeling the pressure to follow suit to the largest rate cut by the Fed since 2008.
- Central banks of Australia and Malaysia have cut rates already while others such as the Bank of Japan, Bank of England and the European Central Bank are contemplating joining the caravan.
Will the Rate Cut be effective?
- Monetary policy is excellent to address demand shocks but is a blunt tool when it comes to addressing supply-side issues.
- A rate cut can, at best, help to boost sentiment but that again will be transient as the market’s reaction after the Fed rate cut proves.
What are RBI’s Options?
- With monetary policy turning out to be the de facto first line of economic defence against the ill-effects of the virus, the focus in India has turned to the Reserve Bank of India’s response.
- Unlike other countries, the legal framework in India after the setting up of the Monetary Policy Committee (MPC) is such that the RBI cannot unilaterally adjust rates.
- The MPC will have to meet and deliberate on the situation before the call to cut rates is taken and such a call will have to be based on an assessment of inflation in the economy.
- Given the MPC constraint, the RBI may well choose to do what it did in the February 2020 monetary policy – announcing another tranche of long-term repo operation.
- That will mean that banks will gain access to three-year funds at the repo rate of 5.15%, much lower than the market rate.
- And then, there’s Operation Twist which the RBI employed to good effect in December, softening rates at the long end of the yield curve.
Operation Twist
- ‘Operation Twist’ is when the central bank uses the proceeds from sale of short-term securities to buy long-term government debt papers, leading to easing of interest rates on the long term papers.
- This is expected to lead to a flattening of the yield curve. Long-end rates are expected to come off, while short-term rates could rise
