58190 141035 Monetary Policy

8/8/2019 58190 141035 Monetary Policy

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Monetary Policy

RBI and Monetary Policy in India

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Monetary Magnitudes

M1 = Currency with public+

Demand deposits with banks+

Other Deposits with RBI M2 = M1+ Post Office Deposits

M3 = M1+ Time Deposits with Banks

M4 = M3+ Total Post Office Deposits

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Growth of M3 and DifferentialContribution of Components

Source: RBI-Macroeconomic and Monetary Developments: Third Quarter Review 2005-06

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What is Monetary Policy?

The term monetary policy refers to actions takenby central banks to affect monetary magnitudesor other financial conditions.

Monetary Policy operates on monetarymagnitudes or variables such as money supply,interest rates and availability of credit.

Monetary Policy ultimately operates through itsinfluence on expenditure flows in the economy.

In other words affects liquidity and by affectingliquidity, and thus credit, it affects total demandin the economy.

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Credit Policy Central Bank may directly affect the money

supply to control its growth. Or it might act indirectly to affect cost and

availability of credit in the economy. In modern times the bulk of money in developed

economies consists of bank deposits rather thancurrencies and coins. So central banks today guide monetary

developments with instruments that control over deposit creation and influence general financialconditions.

Credit policy is concerned with changes in thesupply of credit.

Central Bank administers both the Credit and

Monetary policy

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Aims of Monetary policy

MP is a part of general economic policy of thegovt. Thus MP contributes to the achievement of the

goals of economic policy.

Objective of MP may be:Full employmentStable exchange rateHealthy BoP

Economic growthReasonable Price StabilityGreater equality in distribution of income & wealth

Financial stability

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Price Stability: The Dominant

Objective There is convergence of views in developed anddeveloping economies, that price stability is thedominant objective of monetary policy.

Price stability does not mean complete year-to-year price stability which is difficult to attain.

Price stability refers to the long run average

stability of prices. Price stability involves avoidance of bothinflationary and deflationary pressures.

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Contd..

Price Stability contributes improvements in thestandard of living of people. It promotes saving in the economy while

discouraging unproductive investment. Stable prices enable exports to compete in

international markets and contribute to thestrengthening of BoP.

Price stability leads to interest rate stability, andexchange rate stability (via export import

stability). It contributes to the overall financial stability of the economy.

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Operation of Monetary

Policy

Instruments

1. Discount Rate

(Bank Rate)

2.Reserve Ratios

3. Open Mar ket

Operations

Operating

Tar get

Monetary Base Bank Credit

Interest Rates

Intermediate

Tar get

Monetary

Aggregates(M3)Long term

interest rates

Ultimate

Goals

Total Spending

Price Stability

Etc.

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Instruments of Monetary Policy

Variations in Reserve Ratios

Discount Rate (Bank Rate)

(also called rediscount rate) Open Market Operations (OMOs)

Other Instruments

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Variations in Reserve Ratios

Banks are required to maintain a certainpercentage of their deposits in the form of reserves or balances with the RBI

It is called Cash Reserve Ratio or CRR

Since reserves are high-powered moneyor base money, by varying CRR, RBI can

reduce or add to the bank¶s requiredreserves and thus affect bank¶s ability tolend.

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Discount Rate (Bank Rate) Discount rate is the rate of interest charged by the

central bank for providing funds or loans to thebanking system.

Funds are provided either through lending directly or rediscounting or buying commercial bills and

treasury bills. Raising Bank Rate raises cost of borrowing by

commercial banks, causing reduction in creditvolume to the banks, and decline in money supply.

Variation in Bank Rate has an effect on thedomestic interest rate, especially the short termrates.

Market regards the increase in Bank rate as theofficial signal for beginning of a tight money

situation.

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Open Market Operations (OMOs)

OMOs involve buying (outright or temporary) and selling of govt securitiesby the central bank, from or to the public

and banks. RBI when purchases securities, pays the

amount of money by crediting the reserve

deposit account of the seller¶s bank, whichin turn credits the seller¶s deposit accountin that bank.

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RBI Annual Policy Statement

for 2006-07:April 18, 2006

Highlights Focus on credit quality and financial market conditions for

maintaining macroeconomic, in particular, financial stability. Monetary and interest rate environment enabling growth

momentum consistent with price stability. Bank Rate, Reverse Repo Rate, Repo Rate and Cash Reserve

Ratio kept unchanged. GDP growth projection for 2006-07 at 7.5-8.0 per cent. Inflation to be contained within 5.0-5.5 per cent during 2006-

07. M3 projected to expand by around 15.0 per cent for 2006-07. In normal circumstances, the policy preference would be for

maintaining a lower order of money supply growth in 2006-07. Deposits projected to grow by around Rs.3,30,000 crore for

2006-07.

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Adjusted non-food credit projected to increase by around 20per cent, implying a calibrated deceleration from a growth of around 30 per cent ruling currently.

Appropriate liquidity to be maintained to meet legitimate creditrequirements, consistent with price and financial stability. Primary Dealers to be permitted to diversify their activities. Barring the emergence of any adverse and unexpected

developments in various sectors of the economy and keepingin view the current assessment of the economy including theoutlook for inflation, the overall stance of monetary policy atthis juncture will be:

to ensure a monetary and interest rate environment thatenables continuation of the growth momentum consistent withprice stability while being in readiness to act in a timely and

prompt manner on any signs of evolving circumstancesimpinging on inflation expectations. to focus on credit quality and financial market conditions to

support export and investment demand in the economy for maintaining macroeconomic, in particular, financial stability.

to respond swiftly to evolving global developments.

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Annual Policy Statement

2006-07The Statement consists of two parts: Part I. Annual Statement on Monetary Policy for the Year 2006-07; and Part II. Annual Statement on Developmental and RegulatoryPolicies for the Year 2006-07.

PART I

Domestic Developments The upward revision of real GDP growth to 7.5-8.0 per cent in the Third Quarter Review of January 24, 2006 turned out to be in alignment with the advance estimateof the Central Statistical Organisation at 8.1 per cent for 2005-06, up from 7.5 per cent in the previous year.

Inflation, measured by variations in the wholesale price index (WPI) on a year-on-year basis, was 4.0 per cent at end-March 2006 and3.5 per cent as on April 1, 2006 after receding from a peak of 6.0 per cent on April23, 2005.

The average price of the Indian basket of international crude oil ruled at around US $60.1 per barrel in January-March, 2006 higher by 30.2 per cent than a year ago.

The year-on-year M3 growth was 16.2 per cent (Rs.3,77,238 crore) in 2005-06(March 31, 2006 over April 1, 2005) as compared with 12.1 per cent (Rs.2,42,260crore), net of conversion, in the previous year.

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Excluding the end-March effect, the year-on-year increase in aggregate depositsduring 2005-06 (March 31, 2006 over April 1, 2005) was 16.9 per cent (Rs.3,02,534crore) as against an increase of 12.8 per cent (Rs.1,92,269 crore), net of conversion,in the previous year.

Excluding the end-March build-up, the year-on-year increase in non-food bank creditduring 2005-06 (over April 1, 2005) was 30.8 per cent (Rs.3,42,493 crore) on top of 27.5 per cent (Rs.2,21,602 crore), net of conversion, a year ago.

Financial markets remained generally stable during 2005-06 although interest ratesfirmed up in all segments and the uncollateralised overnight call market experiencedpersistent tightness during the last quarter of the year.

A noteworthy and desirable development during the year was the substantial

migration of money market activity from the uncollateralised call money segment tothe collateralised market repo and collateralised borrowing and lending obligations(CBLO) markets.

The total overhang of liquidity as reflected in outstandings under the Liquidity Adjustment Facility (L AF), the Market Stabilisation Scheme (MSS) and surplus cashbalances of the Central Government taken together declined from an average of Rs.1,14,192 crore in March 2005 to Rs.74,334 crore in March 2006.

For the first time since 1969, investment by SCBs in Government and other approvedsecurities declined by Rs.11,576 crore in 2005-06 in contrast to an increase of Rs.49,373 crore, net of conversion, in 2004-05.

During 2005-06, the Central Government¶s net market borrowings at Rs.95,370 crorewere 86.5 per cent of the budgeted amount of Rs.1,10,291 crore and gross marketborrowings of Rs.1,58,000 crore were 88.5 per cent of the budgeted amount of Rs.1,78,487 crore.

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Exter nal Developments

In US dollar terms, merchandise exports increased by 24.7 per centduring 2005-06 as compared with 26.4 per cent in the previous year.Imports showed an increase of 31.5 per cent as compared with 36.4per cent in the previous year.

While the increase in oil imports was higher at 46.8 per cent as

compared with 45.2 per cent in the previous year, non-oil importsshowed an increase of 25.6 per cent as compared with 33.3 per centin the previous year.

India¶s foreign exchange reserves increased by US $ 10.1 billionfrom US $ 141.5 billion at end-March 2005 to US $ 151.6 billion byend-March 2006.

The foreign exchange market remained orderly in 2005-06 with theexchange rate exhibiting two-way movements. During 2005-06, therupee depreciated by 1.9 per cent against the US dollar butappreciated by 4.4 per cent against the euro, by 5.5 per cent againstthe pound sterling and by 7.5 per cent against Japanese yen.

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Global Developments

± Global growth moderated in the fourth quarter (Q4) of 2005, but is estimated to have risen to 4.8 per cent by theInternational Monetary Fund (IMF) for the full year in view

of the broad-based expansion in economic activity. ± Though price stability has been maintained in major

industrial countries in the face of the oil shock, risks loomlarge in the form of lagged second order effects of oil priceincreases, geopolitical tensions, the probability of disorderly and rapid adjustment of current account

imbalances and the risks emanating from the housingmarket, particularly when the cycle turns down.

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Overall Assessment Macroeconomic and financial conditions have evolved as

stronger than expected. Inflation has been contained well within the projected range as

reflected in the relative stability of long-term interest rates. There are indications of improvement in the fiscal situation and

the return to the path of correction set by the Fiscal

Responsibility and Budget Management Rules. Global growth has also exhibited considerable resilience. Downside risks to the economic outlook internationally continue

in the form high and volatile oil prices, geo-political tensions andsupply shocks, elevated asset prices, global imbalances and

tightening of monetary policy globally. In the domestic economy, non-food credit growth, depositgrowth and money supply growth were higher than theprojections.

Asset prices have registered a substantial increase.

Ensuring credit quality and increasing the pace of investment ininfrastructure is important.

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Stance of Monetary Policy

± GDP growth may be placed in the range of 7.5-8.0 per cent during 2006-07assuming accelerated growth in agriculture under normal monsoonconditions and barring domestic or external shocks.

± The policy endeavour would be to contain the year-on-year inflation rate for 2006-07 in the range of 5.0-5.5 per cent.

± The expansion in M3 is projected at around 15.0 per cent for 2006-07 eventhough the policy preference would be for maintaining a lower order of money supply growth in 2006-07.

± The growth in aggregate deposits is projected at around Rs.3,30,000 crorein 2006-07.

» Year-on-year adjusted non-food credit is expected to increase byaround 20 per cent, a calibrated deceleration from a growth of above30 per cent ruling currently.

» It is necessary to keep in view the dominance of domestic factors as inthe past but to assign more weight to global factors than before whileformulating the policy stance.

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» The Reserve Bank will continue to ensure that appropriateliquidity is maintained in the system so that all legitimaterequirements of credit are met, consistent with the objective of

price and financial stability. Towards this end, RBI will continuewith its policy of active demand management of liquidity throughOMO including MSS, L AF and CRR, and using all the policyinstruments at its disposal flexibly, as and when the situationwarrants.

» Barring the emergence of any adverse and unexpecteddevelopments in various sectors of the economy and keeping inview the current assessment of the economy including the outlookfor inflation, the overall stance of monetary policy at this juncturewill be:

» to ensure a monetary and interest rate environment that enablescontinuation of the growth momentum consistent with pricestability while being in readiness to act in a timely and prompt

manner on any signs of evolving circumstances impinging oninflation expectations.» to focus on credit quality and financial market conditions to

support export and investment demand in the economy for maintaining macroeconomic, in particular, financial stability.

» to respond swiftly to evolving global developments.

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Monetary Measures As on 18 th April 2006:

Bank Rate kept unchanged at 6.0 per cent. Reverse Repo Rate and Repo Rate kept unchanged at 5.5 per cent

and 6.5 per cent, respectively. Cash reserve ratio (CRR) kept unchanged at 5.0 per cent.

As on 15 th Oct 2006:

Policy Rates

Bank Rate: 6% Repo Rate: 7% Reverse Repo Rate: 6%

Reserve Ratios

CRR: 5% SLR: 25%

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Growth of M3 and DifferentialContribution of Components

Source: RBI-Macroeconomic and Monetary Developments: Third Quarter Review 2005-06

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Domestic Developments During 2005-06: real GDP growth projected at around 7.0 %

inflation rate in a range of 5.0-5.5 % andMoney supply (M3) growth rate at 14.5 %

For 2004-05: GDP growth placed at 6.9 %

Inflation rate stood at 5.0 % at end-March 2005.M3 increased by 12.8 %.

RBI¶s foreign currency assets increased by Rs.1,15,044

Crore.

The expansionary impact of foreign currency assets wasneutralised to a large extent by market stabilisation scheme(MSS) in conjunction with reverse repo operations under

liquidity adjustment facility (L AF).

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Non-food credit increased by 26.5 per cent.

Total flow of funds from Scheduled Commercial

Banks increased by 23.6 per cent exceeding thegrowth of 19.0 per cent anticipated in October 2004.

Combined market borrowings of the Centre andStates were lower.

During 2004-05, financial markets remainedgenerally stable.

While interest rates in money and government

securities markets rose intra-year, they stabilised inthe later part of the year, albeit at higher levels.

While the share of sub-PLR lending rose, lendingrates remained stable.

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Exter nal Developments Exports in US dollar terms increased by 27.1 per

cent while Imports by 36.4 per cent leading towidening of trade deficit to US $ 23.8 billionduring 2004-05 (upto February).

During 2004-05 ( April-December), current

account showed a deficit of US $ 7.4 billion asagainst a surplus of US $ 4.8 billion in thecorresponding period of the previous year,

Net accretion to foreign exchange reserves,including valuation changes, amounted to US $

18.2 billion during April-December 2004. Indian foreign exchange market witnessed

orderly condition with rupee exhibiting two-waymovements.

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Global Developments

Though world economy is projected toslow to 4.3 per cent in 2005, expansion isabove trend.

Oil price appears to have larger permanent component.

Risk to growth arises from current account

and fiscal imbalances necessitatingexchange rate adjustment.

The global financial system is stable butrisks have increased.

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Stance of Monetary PolicyOverall stance of monetary policy for the year 2005-06 is:

(i) Provision of appropriate liquidity to meet creditgrowth and support investment and export demand inthe economy while placing equal emphasis on price

stability,(ii) Consistent with the above, to pursue an interest

rate environment that is conducive to macroeconomicand price stability, and maintaining the momentum of

growth, and(iii) To consider measures in a calibrated manner, in

response to evolving circumstances with a view tostabilising inflationary expectations.

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Monetary Measures 2005-06

Bank Rate kept unchanged at 6.0 per cent

Reverse Repo Rate increased by 25 basis

points to 5.0 per cent. Cash Reserve Ratio kept unchanged at

5.0 per cent.

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Developmental and Regulatory Policies

Status quo on the administered interest rates on(i) savings deposit accounts,(ii) non-resident Indian (NRI) deposits,(iii) small loans up to Rs.2 lakh and(iv) export credit.

Effective June 11, 2005, non-bank participants would be allowed to

lend up to 10 per cent of their average daily lending in call/noticemoney market during 2000-01. Effective August 6, 2005, non-bank participants would be completely

phased out from the call/notice money market. Consolidation of debt and building up of large liquid securities in

consultation with the Government while continuing the programmeof reissuances.

Post-FRBM, functional separation between debt management andmonetary operations within RBI. For this purpose, RBI will havediscussions with market players on the modalities and procedures of market operations.

Following the recommendation of the Twelfth Finance Commission,RBI would facilitate the smooth transition of States' market

borrowing through consultation with the Central and the stategovernments.

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To raise the ceiling of overseas investment by Indianentities in overseas joint ventures and/or wholly ownedsubsidiaries from 100 per cent to 200 per cent of their net worth under the automatic route.

To accord general permission to Authorised Dealers( ADs) to open foreign currency accounts of the projectoffices set up in India by foreign companies and operatethe accounts flexibly.

RBI has set up an Expert Group to formulate strategy for

increasing investment in agriculture. Survey to assess customer satisfaction on credit delivery

in rural areas by banks-- proposed. It is proposed to increase the limit on loans to farmers

through produce marketing scheme from Rs.5 lakh to

Rs.10 lakh under priority sector lending. Banks urged to continue their efforts to step up credit to

agriculture. RBI has enabled NGOs to access External Commercial

Borrowings up to US $ 5 million

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The Reserve Bank is reviewing all its existing guidelineson financing small scale sector, debt restructuring,

nursing of sick units, etc with a view to rationalising,consolidating and liberalising them.

Under a scheme to be drawn up by the RBI, banks willbe encouraged to establish mechanisms between their

branches and branches of SIDBI for enhancing credit tosmall industries.

The Reserve Bank will explore modalities to meet thegrowing financial needs of medium enterprises.

RBI is in the process of reviewing the performance of RRBs (Regional rural Banks) and exploring restructuringof RRBs.

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To issue guidelines on merger and amalgamationbetween private sector banks and with NBFCs.

The principles underlying these guidelines wouldalso be applicable as appropriate to public sector banks, subject to relevant legislation.

Banks are urged to refocus on deposit mobilisationand empower the depositors, by providing wider

access and better quality of banking services. RBI will implement policies to encourage bankswhich provide extensive services whiledisincentivising those which are not responsive tothe banking needs of the community, including the

underprivileged.

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To set up an independent Banking Codes andStandards Board of India on the model of the

mechanism in the UK in order to ensure thatcomprehensive code of conduct for fair treatment of customers are evolved and adheredto.

To issue appropriate guidelines to banks to

ensure transparency and disclosure of information by the card issuing banks andcustomer rights protection including facilitatingenforcement of such rights.

In order to maintain consistency and harmonywith international standards, banks advised toadopt Standardised Approach for credit risk andBasic Indicator Approach for operational riskwith effect from March 31, 2007.

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The Reserve Bank would enter into bank-wise dialoguesrelating to ownership and governance in private banks toensure a time-bound framework for compliance.

On the basis of the feedback, the draft guidelines onsecuritisation of standard assets would be finalised.

The guidelines on sale/purchase of non-performingassets would be finalised on the basis of feedback.

The Report of the Working Group on Conflicts of Interestin the Indian Financial Services Sector (Chairman: ShriD.M. Satwalekar) would be put in the public domain for wider dissemination before recommending for adoption.

The Vision Document for Payment and SettlementSystems indicating action points would be placed in the

public domain for wider dissemination. A Board for Regulation and Supervision of Payment and

Settlement Systems (BPSS) was constituted as aCommittee of the Central Board of RBI

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The Reserve Bank proposes to operationaliseNational Electronic Funds Transfer (NEFT)System and NEFT (Extended).

In order to facilitate the technology plans of thefinancial sector, RBI is preparing a FinancialSector Technology Vision Document whichwould be put in the public domain.

RBI is examining the issue of smooth flow of bank finance to NBFCs. The Standing Committee on Procedures and

Performance Audit on Public Services(Chairman: S.S. Tarapore) constituted by RBI

has ceased its operations in March 2005. In order to facilitate regular monitoring, Ad hoc

Committees in banks have been converted topermanent Standing Committees on Customer Service.

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Edmund Phelps' Economic Theory on

Unemployment and Inflation

Edmund Phelps, the 2006 Nobel Prize winner in Economics helped establish the relationship between unemploymentand inflation²and what the Fed can and can't do about

jobs

In the 1960s, along with famed Chicago economist Milton Friedman, Phelps helped create the concept caled the"natural rate of unemployment or NRU."

NRU is also called the "long-run rate of unemployment" or the "non-accelerating inflation rate of unemployment or NAIRU ".

What the natural or long-run rate means is this: If unemployment is lower than its "natural rate," then inflation tends to increase. If unemployment is greater than the natural rate, then inflation tends to fall.

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Why Phelps' Theory was important? Before Phelps and Friedman, many macroeconomists

believed that it was possible to permanently lower theunemployment rate if the Federal Reserve was willing tocut rates and accept more inflation.

But Phelps and Friedman, in separate research, ar guedthat the stimulative effect of low rates would eventually

wear off and unemployment would rise back to the naturalrate, leaving behind a higher inflation rate.

An important implication of Phelps's wor k is that the long-term rate of unemployment cannot be changed by

monetary or fiscal policy. While the Fed can fight recessions by cutting interest

rates, it can't expect to permanently boost employmentonce the recession is over .

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Contd« The conduct of monetary policy today is also influenced by

Phelps' wor k.

Central banker s have given up on the idea that interest-ratechanges can influence the long-run rate of unemployment. Instead, they concentrate on controlling inflation.

One tool: If the unemployment rate is below its long-run level, then the Fed is more likely to raise interest rates.

The US Bureau of Labor Statistics just reported that theunemployment rate was 4.6% in September2006.

Joel Prakken, chairman of Macroeconomic Adviser s, estimates that the natural rate is around 5.25%, though it

could be as much as a half-point higher or lower . Behravesh pegs it somewhat lower , per haps between 4.5%and 5%.

In either case, unemployment has fallen close to the levelthat would create an acceleration of wage growth. Thatwould mean the Fed might be more likely to raise rates.

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Why is the Nobel committee just

honoring Phelps now? By reaching back to Phelps, the Nobel prize

committee is tacitly acknowledging that old wine stillmay be the best.

N. Greg Mankiw, a Harvard professor and former

chairman of the Council of Economic Adviser s, recently wrote: "The sad truth is that themacroeconomic research of the past three decades has had only minor impact on the practical analysis of monetary or fiscal policy."

Adds Prakken: "The neoclassical paradigm thatevolved in the 1960s is still the best or ganizing framewor k to think about the economy."

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