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. Instruments • 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.

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 bank’s required reserves and thus affect bank’s 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 seller’s bank, which in turn credits the seller’s 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 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.

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. • 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.

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%

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 %. • 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).

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 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.

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."