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Monetary Policy
RBI and Monetary Policy in India
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
Growth of M3 and Differential
Contribution of Components
Source: RBI-Macroeconomic and Monetary Developments: Third Quarter Review 2005-06
What is Monetary Policy?
• The term monetary policy refers to actions taken
by central banks to affect monetary magnitudes
or other financial conditions.
• Monetary Policy operates on monetary
magnitudes or variables such as money supply,
interest rates and availability of credit.
• Monetary Policy ultimately operates through its
influence on expenditure flows in the economy.
• In other words affects liquidity and by affecting
liquidity, and thus credit, it affects total demand
in the economy.
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 than
currencies and coins.
• So central banks today guide monetary
developments with instruments that control over
deposit creation and influence general financial
conditions.
• Credit policy is concerned with changes in the
supply of credit.
• Central Bank administers both the Credit and
Monetary policy
Aims of Monetary policy
• MP is a part of general economic policy of the
govt.
• Thus MP contributes to the achievement of the
goals of economic policy.
• Objective of MP may be:
Full employment
Stable exchange rate
Healthy BoP
Economic growth
Reasonable Price Stability
Greater equality in distribution of
income & wealth
Financial stability
Price Stability: The Dominant
Objective
• There is convergence of views in developed and
developing economies, that price stability is the
dominant objective of monetary policy.
• Price stability does not mean complete year-toyear price stability which is difficult to attain.
• Price stability refers to the long run average
stability of prices.
• Price stability involves avoidance of both
inflationary and deflationary pressures.
Contd..
• Price Stability contributes improvements in the
standard 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 the
strengthening of BoP.
• Price stability leads to interest rate stability, and
exchange rate stability (via export import
stability).
• It contributes to the overall financial stability of
the economy.
Instruments
1. Discount Rate
(Bank Rate)
2.Reserve Ratios
3. Open Market
Operations
Operation of Monetary
Policy
Operating
Target
• Monetary Base
• Bank Credit
• Interest Rates
Intermediate
Target
•Monetary
Aggregates(M3)
•Long term
interest rates
Ultimate
Goals
•Total Spending
• Price Stability
Etc.
Instruments of Monetary Policy
• Variations in Reserve Ratios
• Discount Rate (Bank Rate)
(also called rediscount rate)
• Open Market Operations (OMOs)
• Other Instruments
Variations in Reserve Ratios
• Banks are required to maintain a certain
percentage 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 money
or base money, by varying CRR, RBI can
reduce or add to the bank’s required
reserves and thus affect bank’s ability to
lend.
Discount Rate (Bank Rate)
• Discount rate is the rate of interest charged by the
central bank for providing funds or loans to the
banking 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 credit
volume to the banks, and decline in money supply.
• Variation in Bank Rate has an effect on the domestic
interest rate, especially the short term rates.
• Market regards the increase in Bank rate as the
official signal for beginning of a tight money
situation.
Open Market Operations (OMOs)
• OMOs involve buying (outright or
temporary) and selling of govt securities
by 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, which
in turn credits the seller’s deposit account
in that bank.
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 200607.
• 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.
• Adjusted non-food credit projected to increase by around 20
per cent, implying a calibrated deceleration from a growth of
around 30 per cent ruling currently.
• Appropriate liquidity to be maintained to meet legitimate credit
requirements, 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 keeping
in view the current assessment of the economy including the
outlook for inflation, the overall stance of monetary policy at
this juncture will be:
• to ensure a monetary and interest rate environment that
enables continuation of the growth momentum consistent with
price stability while being in readiness to act in a timely and
prompt manner on any signs of evolving circumstances
impinging 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.
Annual Policy Statement
2006-07
The 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 Regulatory
Policies 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 estimate
of 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-onyear basis, was 4.0 per cent at end-March 2006 and
3.5 per cent as on April 1, 2006 after receding from a peak of 6.0 per cent on April
23, 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.2,42,260
crore), net of conversion, in the previous year.
•
•
•
•
•
•
•
Excluding the end-March effect, the year-on-year increase in aggregate deposits
during 2005-06 (March 31, 2006 over April 1, 2005) was 16.9 per cent (Rs.3,02,534
crore) 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 credit
during 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 rates
firmed up in all segments and the uncollateralised overnight call market experienced
persistent 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 to
the 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 (LAF), the Market Stabilisation Scheme (MSS) and surplus cash
balances 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 approved
securities 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 crore
were 86.5 per cent of the budgeted amount of Rs.1,10,291 crore and gross market
borrowings of Rs.1,58,000 crore were 88.5 per cent of the budgeted amount of
Rs.1,78,487 crore.
External Developments
• In US dollar terms, merchandise exports increased by 24.7 per cent
during 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 36.4
per 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 imports
showed an increase of 25.6 per cent as compared with 33.3 per cent
in the previous year.
• India’s foreign exchange reserves increased by US $ 10.1 billion
from US $ 141.5 billion at end-March 2005 to US $ 151.6 billion by
end-March 2006.
• The foreign exchange market remained orderly in 2005-06 with the
exchange rate exhibiting two-way movements. During 2005-06, the
rupee depreciated by 1.9 per cent against the US dollar but
appreciated by 4.4 per cent against the euro, by 5.5 per cent against
the pound sterling and by 7.5 per cent against Japanese yen.
Global Developments
– Global growth moderated in the fourth quarter (Q4) of
2005, but is estimated to have risen to 4.8 per cent by the
International 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 loom
large in the form of lagged second order effects of oil price
increases, geopolitical tensions, the probability of
disorderly and rapid adjustment of current account
imbalances and the risks emanating from the housing
market, particularly when the cycle turns down.
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 and
supply shocks, elevated asset prices, global imbalances and
tightening of monetary policy globally.
• In the domestic economy, non-food credit growth, deposit growth
and money supply growth were higher than the projections.
• Asset prices have registered a substantial increase.
• Ensuring credit quality and increasing the pace of investment in
infrastructure is important.
Stance of Monetary Policy
– GDP growth may be placed in the range of 7.5-8.0 per cent during 2006-07
assuming accelerated growth in agriculture under normal monsoon
conditions 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 even
though 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 crore
in 2006-07.
» Year-on-year adjusted non-food credit is expected to increase by
around 20 per cent, a calibrated deceleration from a growth of above
30 per cent ruling currently.
» It is necessary to keep in view the dominance of domestic factors as in
the past but to assign more weight to global factors than before while
formulating the policy stance.
» The Reserve Bank will continue to ensure that appropriate
liquidity is maintained in the system so that all legitimate
requirements of credit are met, consistent with the objective of
price and financial stability. Towards this end, RBI will continue
with its policy of active demand management of liquidity through
OMO including MSS, LAF and CRR, and using all the policy
instruments at its disposal flexibly, as and when the situation
warrants.
» Barring the emergence of any adverse and unexpected
developments in various sectors of the economy and keeping in
view the current assessment of the economy including the outlook
for inflation, the overall stance of monetary policy at this juncture
will be:
» to ensure a monetary and interest rate environment that enables
continuation of the growth momentum consistent with price
stability while being in readiness to act in a timely and prompt
manner on any signs of evolving circumstances impinging 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.
Monetary Measures
As on 18th 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 15th Oct 2006:
Policy Rates
• Bank Rate: 6%
• Repo Rate: 7%
• Reverse Repo Rate: 6%
Reserve Ratios
• CRR: 5%
• SLR: 25%
Growth of M3 and Differential
Contribution of Components
Source: RBI-Macroeconomic and Monetary Developments: Third Quarter Review 2005-06
RBI Annual Policy Statement
for 2005-06: April 28, 2005
The Statement consists of two parts:
Part I. Annual Statement on Monetary Policy for
the Year 2005-06; and
Part II. Annual Statement on Developmental and
Regulatory Policies for the Year 2005-06.
• Review of macroeconomic and monetary
developments was issued, a day in advance, as
a supplement to Part I
• First Quarter Review in July
• Mid-term Review in October,
• Third Quarter Review in January
Domestic Developments
• During 2005-06: real GDP growth projected at around 7.0 %
inflation rate in a range of 5.0-5.5 % and
Money 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 was
neutralised to a large extent by market stabilisation scheme
(MSS) in conjunction with reverse repo operations under
liquidity adjustment facility (LAF).
• Non-food credit increased by 26.5 per cent.
• Total flow of funds from Scheduled Commercial
Banks increased by 23.6 per cent exceeding the
growth of 19.0 per cent anticipated in October 2004.
• Combined market borrowings of the Centre and
States were lower.
• During 2004-05, financial markets remained
generally stable.
• While interest rates in money and government
securities markets rose intra-year, they stabilised in
the later part of the year, albeit at higher levels.
• While the share of sub-PLR lending rose, lending
rates remained stable.
External Developments
• Exports in US dollar terms increased by 27.1 per
cent while Imports by 36.4 per cent leading to
widening of trade deficit to US $ 23.8 billion
during 2004-05 (upto February).
• During 2004-05 (April-December), current
account showed a deficit of US $ 7.4 billion as
against a surplus of US $ 4.8 billion in the
corresponding 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-way
movements.
Global Developments
• Though world economy is projected to
slow to 4.3 per cent in 2005, expansion is
above trend.
• Oil price appears to have larger
permanent component.
• Risk to growth arises from current account
and fiscal imbalances necessitating
exchange rate adjustment.
• The global financial system is stable but
risks have increased.
Stance of Monetary Policy
Overall stance of monetary policy for the year 2005-06 is:
(i)
Provision of appropriate liquidity to meet credit
growth and support investment and export demand in
the economy while placing equal emphasis on price
stability,
(ii) Consistent with the above, to pursue an interest
rate environment that is conducive to macroeconomic
and 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 to
stabilising inflationary expectations.
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.
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/notice
money 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 programme
of reissuances.
• Post-FRBM, functional separation between debt management and
monetary operations within RBI. For this purpose, RBI will have
discussions 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 state
governments.
• To raise the ceiling of overseas investment by Indian
entities in overseas joint ventures and/or wholly owned
subsidiaries 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 project
offices set up in India by foreign companies and operate
the 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
• The Reserve Bank is reviewing all its existing guidelines
on 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 will
be encouraged to establish mechanisms between their
branches and branches of SIDBI for enhancing credit to
small industries.
• The Reserve Bank will explore modalities to meet the
growing financial needs of medium enterprises.
• RBI is in the process of reviewing the performance of
RRBs (Regional rural Banks) and exploring restructuring
of RRBs.
• To issue guidelines on merger and amalgamation
between private sector banks and with NBFCs.
• The principles underlying these guidelines would
also be applicable as appropriate to public sector
banks, subject to relevant legislation.
• Banks are urged to refocus on deposit mobilisation
and empower the depositors, by providing wider
access and better quality of banking services.
• RBI will implement policies to encourage banks
which provide extensive services while
disincentivising those which are not responsive to
the banking needs of the community, including the
underprivileged.
• To set up an independent Banking Codes and
Standards Board of India on the model of the
mechanism in the UK in order to ensure that
comprehensive code of conduct for fair
treatment of customers are evolved and adhered
to.
• To issue appropriate guidelines to banks to
ensure transparency and disclosure of
information by the card issuing banks and
customer rights protection including facilitating
enforcement of such rights.
• In order to maintain consistency and harmony
with international standards, banks advised to
adopt Standardised Approach for credit risk and
Basic Indicator Approach for operational risk with
effect from March 31, 2007.
• The Reserve Bank would enter into bank-wise dialogues
relating to ownership and governance in private banks to
ensure a time-bound framework for compliance.
• On the basis of the feedback, the draft guidelines on
securitisation of standard assets would be finalised.
• The guidelines on sale/purchase of non-performing
assets would be finalised on the basis of feedback.
• The Report of the Working Group on Conflicts of Interest
in the Indian Financial Services Sector (Chairman: Shri
D.M. Satwalekar) would be put in the public domain for
wider dissemination before recommending for adoption.
• The Vision Document for Payment and Settlement
Systems 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 a
Committee of the Central Board of RBI
• The Reserve Bank proposes to operationalise
National Electronic Funds Transfer (NEFT)
System and NEFT (Extended).
• In order to facilitate the technology plans of the
financial sector, RBI is preparing a Financial
Sector Technology Vision Document which
would 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 to
permanent Standing Committees on Customer
Service.
Edmund Phelps' Economic Theory on
Unemployment and Inflation
• Edmund Phelps, the 2006 Nobel Prize winner in Economics
helped establish the relationship between unemployment
and inflation—and 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.
Why Phelps' Theory was important?
• Before Phelps and Friedman, many macroeconomists
believed that it was possible to permanently lower the
unemployment rate if the Federal Reserve was willing to
cut rates and accept more inflation.
• But Phelps and Friedman, in separate research, argued
that the stimulative effect of low rates would eventually
wear off and unemployment would rise back to the natural
rate, leaving behind a higher inflation rate.
• An important implication of Phelps's work is that the longterm 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 employment
once the recession is over.
Does Phelps' work still matter
today?
• Very much so. Despite more than 30 years of
subsequent research, most macro forecasting
models are still built around some variant of the
natural rate of unemployment.
• Certainly the two leading private forecasters,
St.Louis-based Macroeconomic Advisers and
Global Insight of Waltham, Mass., rely on Phelpstype equations in their models.
• "In the end, we keep coming back to what he's
done," says Nariman Behravesh, chief economist
of Global Insight.
Contd…
• The conduct of monetary policy today is also influenced by
Phelps' work.
• Central bankers have given up on the idea that interest-rate
changes 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 the
unemployment rate was 4.6% in September2006.
• Joel Prakken, chairman of Macroeconomic Advisers,
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, perhaps between 4.5%
and 5%.
• In either case, unemployment has fallen close to the level
that would create an acceleration of wage growth. That
would mean the Fed might be more likely to raise rates.
Why is the Nobel committee just
honoring Phelps now?
• By reaching back to Phelps, the Nobel prize
committee is tacitly acknowledging that old wine still
may be the best.
• N. Greg Mankiw, a Harvard professor and former
chairman of the Council of Economic Advisers,
recently wrote: "The sad truth is that the
macroeconomic 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 that
evolved in the 1960s is still the best organizing
framework to think about the economy."