How RBI Sets Interest Rates in India

The Reserve Bank of India, on June 7, 2024, left the policy repo rate unchanged at 6.5 per cent for the eighth meeting in a row. The central bank last changed its key interest rate in February 2023, when it announced a 25-basis-point increase to tackle rising inflation.
 

That rate hike was the final one in a year-long monetary tightening cycle which saw the repo rate being increased by a massive 250 basis points. As such, the next move is widely anticipated to be a rate cut. To understand when that could happen, it is crucial to know how the Reserve Bank of India decides the course of monetary policy.
 

The Monetary Policy Committee
 

The level of interest rate in the country is decided by the Monetary Policy Committee, which is a part of the Reserve Bank of India. The Monetary Policy Committee is a fairly new creation. It was set up in 2016, until which the governor of the Reserve Bank of India was single-handedly responsible for the interest rate decision.
 

Each member of the MPC gets one vote. While this can result in a delicate situation considering the committee has six members, in the event that the vote is split three-three, the governor gets a second – or ‘casting’ – vote to break the deadlock. So far, in the near-eight-year history of the MPC, no RBI governor has had to use their casting vote as each decision of the committee has been decided by a clear majority, be it 6-0, 5-1, or 4-2.
 

Mandate of the MPC
 

The setting up of the MPC in late 2016 was one half of a monumental change in India’s monetary policy decision making process. Not only did the government and the Reserve Bank of India found common ground to put in place a law which stated that six people, and not just one, would vote to fix the repo rate, it was also decided that the decision to do so would be on the basis of an explicit inflation target.
 

The inflation target has been set at 4 per cent within a range of 200 basis points on either side, effectively resulting in a target band of 2 per cent to 6 per cent. This target is not for eternity and is reviewed every five years. It was last set in March 2021 and is valid until March 2026.
 

Crucially, the Reserve Bank of India is said to have failed to meet its inflation mandate when average inflation is outside the 2-6 per cent for three consecutive quarters. The indicator used for this is Consumer Price Index inflation, which measures retail inflation levels in the country.
In the event of failure, the Reserve Bank must write a report to the Indian government explaining why it failed, the remedial actions it would take, and an estimate of the time within which inflation would return to 4 per cent.
 

Interestingly, inflation is not the sole mandate of the Indian central bank. According to the Reserve Bank of India Act, the “primary objective of the monetary policy is to maintain price stability while keeping in mind the objective of growth”. However, unlike inflation, the law does not set out a numerical target for growth. But what this additional statement does is prevent the Reserve Bank for single-mindedly focusing on bringing down inflation without any consideration for the consequent growth sacrifice.
 

RBI half of MPC
 

So who finally votes on the interest rate decision?
 

There is, of course, the governor of the Reserve Bank of India. At the moment, it is Shaktikanta Das, who assumed charge as the chief of the Indian central bank in December 2018.
 

The second representative from the Reserve Bank of India on the MPC is the Deputy Governor in charge of monetary policy. The central bank has many departments, with one of its deputy governors heading each one of them. At the moment, Michael Patra is the deputy governor in charge of the Monetary Policy Department and, as such, serves as a member of the MPC.
 

The third and final representative of the Reserve Bank on the MPC is any officer of the central bank who is nominated by its Central Board of Directors. While this can be any RBI officer, the board has usually picked the executive director part of the Monetary Policy Department for this position. At the moment, it is occupied by Rajiv Ranjan.
 

The MPC’s external members
 

In addition to the three representatives of the Reserve Bank, the MPC also contains what are called three external members. These members are selected by the Indian government and are experts in the field of economics, banking, finance, or monetary policy.
 

The current set of external members on the MPC are Shashanka Bhide, Honorary Senior Advisor at National Council of Applied Economic Research; Ashima Goyal, Emeritus Professor at Indira Gandhi Institute of Development Research; Jayanth Varma, Professor at Indian Institute of Management, Ahmedabad.
 

External members serve a four-year term.
 

Why MPC memberships matter for interest rates
 

The changes to India’s interest rate decision process over the last decade have been revolutionary. Not only did they make it rule-based, they also removed it from one person’s hands – the government of the Reserve Bank – and put it in the hands of many. While the former introduced a level of objectivity, the latter has made the process less predictable.
 

This is because members of the MPC keep changing. Take the external members, for instance, who all serve four-year terms. The current set of external members will hold their last meeting in August 2024 and must be replaced with three new members for the October 2024 meeting. The three new members could hold entirely differently opinions on interest rates, inflation, and growth. As such, the balance of votes on the committee can shift dramatically.
 

The same holds true for the representatives from the RBI. Shaktikanta Das’ second term as the governor ends in December 2024. His successor would be a new element on the MPC and could also re-shape the votes of the two other representatives of the RBI on the committee.