Understanding Monetary Policy

Mythili Bhusnurmath
 Policy Levers of Growth

Two policy levers available to authorities

• Monetary policy : domain of central bank

• Fiscal policy : domain of govt

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What is Monetary Policy?

Refers to the process by which the

monetary authority - usually central bank -
controls money supply and in turn the cost
of money (short-term money) to ensure
price stability and trust in the currency

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Monetary policy Indian context

In the Indian context, RBI has been

vested with responsibility for conduct of
monetary policy under RBI Act 1934 to
achieve the goals specified under the Act

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Monetary Policy Objectives in India
• Primary objective: maintain price stability while
keeping in mind the objective of growth.

• RBI Act, 1934 amended in May 2016 to provide a

statutory basis for the implementation of the
flexible inflation targeting framework.
• Amended RBI Act provides for inflation target to
be set by the Government of India, in
consultation with the Reserve Bank, once in every
five years.
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How does the RBI do this?
Monetary Policy Instruments
• Repo Rate: The (fixed) interest rate at which
RBI provides overnight liquidity to banks
against collateral of government and other
approved securities under the liquidity
adjustment facility (LAF).
• Reverse Repo Rate: The (fixed) interest rate
at which RBI absorbs liquidity, on an overnight
basis, from banks against the collateral of
eligible government securities under the LAF.
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Monetary Policy Instruments
• Statutory Liquidity Ratio (SLR): The
share of NDTL a bank is required to
maintain in safe and liquid assets, such
as, unencumbered government
securities, cash and gold.
• Cash Reserve Ratio (CRR): Average
daily balance a bank must maintain with
RBI as a % of Net demand and time
liabilities (NDTL)
 Monetary Policy Instruments
• Open Market Operations (OMOs): Purchase &
sale of government securities, for injection &
absorption of liquidity, respectively.
• Marginal Standing Facility (MSF): Allows banks to
borrow additional overnight money from RBI by
dipping into their SLR portfolio up to a limit at a
penal rate of interest.
• Provides a safety valve against unanticipated
liquidity shocks to the banking system
More monetary policy instruments

• Market Stabilisation Scheme (MSS):

Introduced in 2004. Surplus liquidity of
a more enduring nature arising from
large capital inflows is absorbed through
sale of short-dated government
securities & treasury bills.

• Cash so mobilised is held in a separate

government account with RBI.
Position Pre IT (inflation targeting) regime

• Historically India has suffered from high

inflation
• Post GFC in 2008 and the stimulus
package adopted by India, inflation was
close to double digits
• Inflation in India was among highest in
G20 countries
• Serious economic, political and social
repercussions
Why is high inflation bad?
1. Real interest rates will fall/become
negative for savers leading to a fall in
domestic financial savings.
2. Inflation higher than trading partners
erodes external competitiveness.
3. Nominal exchange rate adjustment to
offset inflation differential can set off a
depreciation-inflation spiral, undermining
macroeconomic stability
Ills of high inflation
4. Increased demand for gold as a hedge
against inflation can result in a widening
of the current account deficit.
5.Persistently high inflation adversely
impacts the economy’s allocative effi
ciency and impedes growth
6. Contributes to a worsening of income
distribution as poor use disproportionately
higher cash
Context for shift to Inflation
targeting regime
• High inflation in 2008-2014 prompted
setting up of an expert committee under
then Dy Governor, Urjit Patel to look at
monetary policy framework

• Expert Committee to Revise &

Strengthen Monetary Policy Framework
(Urjit Patel Committee) submitted report
in Jan 2014
 URJIT PATEL COMMITTEE
Key recommendations

• Shift to a flexible inflation targeting

regime
• The target should be CPI (combined)
and policy must be consistent with a
sustainable growth trajectory & financial
stability
Institutional Requirements
• Fiscal deficit : 3% of GPD
• Administered interest rates and wages
must be eliminated
• Decision-making on monetary policy
must be vested with an independent
monetary policy committee (MPC)
• 6 member MPC chaired by RBI governor
• No govt representation on MPC
More on MPC
• Decisions to be taken by majority voting
• Minutes to be released after 2 week lag
• MPC accountable for failure to establish
& achieve nominal anchor for three
successive qtrs
• Failure requires MPC to issue public
statement giving reasons for failure &
proposed remedial action
Operating framework
• Simple rule of positive real policy rate ie
when inflation is > nominal anchor then
interest rate shld be raised to make real
rate positive
• Extent to which it is positive to be
determined by MPC
• In transitional phase, operating rate to
be weighted avg call rate
Targets & Timeframe
• Target : 4% with a band of +/- 2% to
be achieved in phases over a 2 year
horizon:
• 10 to 8% over next 12 months
• 6% over next 24 months
• 4% +/-2% subsequently
 Action on Urjit Patel recos
• Central Government notified Consumer
Price Index (CPI) inflation of 4% +/-2% as
target from August 5, 2016 to March 31,
2021
• Failure defined as :(a) average inflation >
upper tolerance level of the inflation target
for any 3 consecutive quarters;
• (b) average inflation <lower tolerance level
for any three consecutive quarters.
Tools to achieve IT
• Overnight LAF repo rate to be single
policy rate
• Reverse repo and MSF to be fixed wrt
repo rate with a spread of +/-100 bps
• Repo rate to be fixed by MPC
• Spread may be changed
Liquidity management
• Provision of liquidity by RBI at O/N repo
to be ltd to a specified ratio of bank-
wise net demand & time liabilities that is
consistent with price stability
• Term repo market to be developed
• MSF rate to be truly penal rate
• Both debt & cash management function
of govt to be entrusted to government
Experience post IT
• Inflation has come down sharply
• According to latest data (as of August
2019) retail inflation CPI for June 2019
is 3.2%
• Core inflation (excluding food & fuel) is
4.1% (May 2019)
• Reason to celebrate?
Have we been too successful?
• Along with sharp decline in inflation,
growth has also slowed
• GDP growth down from average of 7.2%
in period …to 5.8% in Q4 2018-19
• RBI’s latest (August 2019) estimate of
GDP growth for 2019-20 revised down
to 6.9% from 7% earlier
• Has excessive tightening contributed to
growth slowdown?
Jury is out!!
• RBI now on easing cycle
• Four consecutive cuts in repo rate
starting Feb 2019
• Repo rate cut 25 basis points in Feb,
April, June 2019
• Latest reduction (August 2019) of 35
basis points
• Repo rate now at 5.40% lowest in a
decade
 Billion dollar question

Will this suffice to kick start growth?

Only time will tell !

Monetary policy:New Challenges
• Rise of bitcoin & other crypto currencies
not backed by govt
• Link between money supply and inflation
does not seem to hold as before
• Milton Friedman :Inflation is always
and everywhere a monetary
phenomenon : it is & can be produced
only by a faster increase in the quantity
of money than in output.