Monetary Policy

1
Monetary Policy

• RBI and Monetary Policy in India

2
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

3
Growth of M3 and Differential Contribution of
Components

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

4
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.

5
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

6
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

7
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-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 both
  inflationary and deflationary pressures.

8
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.

9
Operation of Monetary Policy

• Instruments
• Discount Rate
• (Bank Rate)
• 2.Reserve Ratios
• 3. Open Market
• Operations

• Operating
• Target
• Monetary Base
• Bank Credit
• Interest Rates

• Intermediate
• Target
• Monetary
• Aggregates(M3)
• Long term
• interest rates

• Ultimate
• Goals
• Total Spending
• Price Stability
• Etc.

10
Instruments of Monetary Policy

• Variations in Reserve Ratios
• Discount Rate (Bank Rate)
• (also called rediscount rate)
• Open Market Operations (OMOs)
• Other Instruments

11
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 banks required reserves and thus affect
  banks ability to lend.

12
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.

13
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 sellers bank, which in turn credits the
  sellers deposit account in that bank.

14
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.

15

• 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.

16
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-on-year
  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.

17

• 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 Governments 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.

18
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.
• Indias 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.

19
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.

20
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.

21
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.

22

• 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.

23
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

24
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25
Growth of M3 and Differential Contribution of
Components

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

26
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

27
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 .
• RBIs 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).

28

• 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.

29
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.

30
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.

31
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.

32
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.

33
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.

34

• 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

35

• 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.

36

• 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.

37

• 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.

38

• 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

39

• 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.

40
Edmund Phelps' Economic Theory on Unemployment
and Inflation

• Edmund Phelps, the 2006 Nobel Prize winner in
  Economics helped establish the relationship
  between unemployment and inflationand 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.

41
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 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 employment once the recession is over.

42
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 Phelps-type
  equations in their models.
• "In the end, we keep coming back to what he's
  done," says Nariman Behravesh, chief economist of
  Global Insight.

43
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.

44
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."