What Is Monetary Policy And How Does It Affect Your Home Deals? An Explainer

Monetary policy is the process by which central banks attempt to control the money supply to ensure price stability. Another major goal of monetary policy is dampening or eliminating economy-wide fluctuations. Across the world, monetary policy is conducted by central banks. In the United States, for instance, the Federal Reserve conducts monetary policy. In India, the Reserve Bank of India (RBI) is in charge of monetary policy. Even though it is commonly assumed that the RBI can control economic growth and productivity, it is not true that central bank monetary policy has direct control over real economic growth. But, price stability is essential for high, long-term economic growth.

Why is this so, and how does this apply to the residential real estate market?

Uncertainty in real estate market

When inflation is high, there is great uncertainty. For example, a real estate developer in India, who constructs a residential would find it difficult to plan when the value of Rupee fluctuates widely. This is because the contracts between the developer, his employees and home buyers are written in terms of the Indian Rupee without adjusting its value for inflation. Consider this. If an apartment in India would be up for possession in four years, and if inflation is 10 per cent annually in this period, a flat that costs Rs 1 crore today would be worth Rs 1,4,641,000 in four years. In this scenario, even if the payment is spread over many years, the developer would lose money if he does not take the impending decline in the value of money into account.

But inflation in India is highly unpredictable. In November 2013, CPI inflation, the best measure of inflation in India, was 11.2 per cent. Prior to this, India had seen inflation hovering at 8-10 per cent for seven years in a row since 2006. In August 2015, though, CPI inflation had dropped to mere 3.66 per cent.

When inflation is unpredictable, it would be difficult for the developer to budget his expenses or price apartments accurately. The developer can, of course, renegotiate contracts when inflation rises. But, renegotiation is costly because contracting is costly. This is especially difficult in a country like India where many contracts are unwritten.

This applies to the rental residential market too. When inflation is high, rental contracts ought to be repeatedly subject to renegotiation and this is costly. This disrupts contracts in the rental residential market in which many contracts are unwritten. This hinders the development of the rental residential market, lowering the quality and quantity of the dwelling units available for renting.

Such conflicts apply not merely to residential real estate market, but to every sector of the economy. India has greater price stability now, and this matters to home buyers. According to a study by economist Stanley Fischer, an inflation of even 10 per cent, even when it is entirely predictable, would lead to a loss of 0.3 per cent of the GDP because households and firms tend to spend more, holding less cash, driven by fear of losing money in the event of depreciation of currency. For instance, during the phase of hyperinflation in Germany in 1923, people spent most of their savings for fear that the value of money would go down quickly. However, hyperinflation and propensity to spend as a result do not count as the only harmful effect of inflation.

Repo Rate Cuts and Inflation

The RBI could use any instrument, like the repo rate, to raise and lower inflation rates or to meet its inflation targets. Repo Rate is the repurchase rate at which the RBI lends to commercial banks. When the RBI raises the repo rate, interest rates are expected to rise too, leading to low inflation. Similarly, when the RBI slashes the repo rate, interest rates are expected to come down too, leading to rise in inflation.

However, this may not always be the case. Often, owing to unpredictability in the market, banks often do not cut rates even after repo rate cut by the RBI. In late 2009 and early 2010, for example, interest rates at major banks in India remained unaffected even after repo rate cuts by the RBI, as the banks had more than sufficient money and they did not need to borrow from the central bank.

Cost of borrowing

Another way in which monetary policy influences real estate markets is by influencing the cost of borrowing. When the RBI cuts the repo rate, home loan interest rates usually fall and when the RBI raises the repo rate, interest rates usually rise. When home loan interest rates are low, people can buy a much more expensive home with the same equated monthly installment (EMI).

Monetary Policy reforms in India: Inflation targeting

A number of committees, formed to suggest financial sector reforms, have suggested that the RBI should become an inflation targeting central bank. A major way in which the RBI was different from global central banks was that it was not an inflation targeting central bank till recently. However, a groundswell of economic opinion in recent times has veered in favour of an inflation target that the RBI should meet consistently. The RBI must also communicate this target to the public and explain itself when it fails to meet the target. Many economists suggest that the target must be four to five per cent. RBI Governor Raghuram Rajan thinks that the target should be four per cent with inflation lying between two and six per cent being acceptable. In comparison, the inflation targets of the Federal Reserve in the United States and the Bank of England in the United Kingdom is two per cent. The European Central Bank has a target of up to two per cent. In March 2015, the RBI in India too adopted flexible inflation targeting. This is seen as a major reform the RBI has undergone in its history.

Monetary Policy reforms in India: Exchange rate

Another major difference economists see in the way monetary policy is conducted in India is that it focuses on the exchange rate. This is not true of major central banks in the developed world or major emerging economies. Why do economists see this as a flaw? Imagine that the United States Federal Reserve had raised interest rates in the monetary policy meeting in September. If the RBI keeps the interest rates low, there would be less capital flows into India. But, if the RBI raises the interest rates, growth would decline. It is difficult to align India's monetary policy with that of the US because the business cycle in India is not aligned with the business cycle in the US. (Business cycle is the upward and downward movement of the gross domestic product levels.) Moreover, it is difficult for the RBI to manipulate the currency exchange rate and interest rates because they are influenced by many other factors that are beyond the central bank's control. It is also not always clear what the optimal interest rate or currency exchange rate is. When growth is stagnant, a high ratio of Dollar to Rupee would help it recover and vice versa. Many economists think that if the RBI has multiple objectives, it would be accountable for none, and make it difficult for it to focus on its primary objective: Maintaining price stability.

In major central banks across the world, decisions are taken by a monetary policy committee. The Financial Sector Legislative Reforms Commission (FSLRC) had recommended forming a monetary policy committee two years ago. In India, RBI Governor Raghuram Rajan has veto over monetary policy decisions and can override the policy prescriptions of the Technical Advisory Committee (TAC). This is also seen as a flaw because the government can pressurise the governor, but it is more difficult to pressurise a whole committee even if it is appointed by the government. But, the RBI is likely to have a monetary policy committee within a year or so. This is, again, a major reform in the history of RBI.

Monetary Policy reforms in India: Debt management

In India, the RBI also monetises the debt of the Indian government. This means that the RBI buys government securities by paying for them with reserves. Across the world, this is known as open market operations of the central bank. This increases the money supply in the economy, leading to high inflation levels. As this is seen as a situation in which there is a conflict of interest, the government wants to establish an independent Public Debt Management Agency (PDMA). This would be another major reform in the history of the RBI.

It is possible that like all major economies, India too is entering a phase in which price stability is the norm. When this happens, home loan interest rates would fall to the greatest degree possible. Real estate markets would become much more efficient too.