The Hindu Business Line : Understanding monetary policy

Monetary policy is essentially a stabilisation policy. It is not intended to influence the long-term growth potential of the economy, but aims at ironing out the fluctuations in the economy.

MR D. K. JOSHI, DIRECTOR AND PRINCIPAL ECONOMIST, CRISIL.

D. Murali
S. Ramesh

Is inflation under control? Will cost of capital go up? Is it going to be easier to borrow funds? To these and more questions, answers should be available on July 31, when the Reserve Bank of India (RBI) will announce the monetary and credit policy. This will be the second of the four quarterly monetary policy announcements scheduled for 2007-08.

“The announcement is eagerly awaited not only for RBI’s prognosis of the economic conditions but also its prescription for the same,” says Mr D. K. Joshi, Director and Principal Economist, CRISIL. “Monetary policy will seek to answer important questions that impact the well-being of the economy, companies as well as individuals.”

Speaking to Business Line, Mr Joshi emphasises the need to understand the underlying rationale of monetary policy formulation, its instruments, and transmission mechanisms, for a proper perspective of the RBI’s actions.

Excerpts from an interview.

What is monetary policy?

Monetary policy can be summarised as the central bank’s actions to influence the availability and cost of money and credit in the economy. The primary objective of these actions is to ensure price stability.

How does it work?

As an illustration, consider that an economy is growing too fast. This is also referred to as overheating of the economy: a situation that typically happens in the boom phase when GDP (gross domestic product) growth exceeds the long-term growth potential of the economy. The producers of goods are not able to make enough goods to meet the rising demand. The resultant demand-supply mismatch creates inflationary pressures in the economy. This situation is regarded as unsustainable, as the high growth translates into higher inflation. In this situation, the RBI raises interest rates to depress spending and reduce the pressure on inflation.

And in the opposite?

Conversely, when the economy is growing too slowly, interest rates are reduced to stimulate demand.

Does economic growth demand monetary policy?

Monetary policy is essentially a stabilisation policy. It is not intended to influence the long-term growth potential of the economy, but aims at ironing out the fluctuations in the economy also referred to as business cycles. This is done to minimise fluctuations and ensure a sustainable mix of growth and inflation in the economy.

What are the instruments of monetary policy?

The central bank can influence the cost of funds and availability of credit in the economy by altering the repo/reverse repo rates, changing the reserve requirements, and engaging in open market operations.

Repo and reverse repo… as confusing as identical twins!

But they are opposites. Repo is short for repossess or repurchase. Repo rate is the rate that RBI charges the banks when they borrow from it. Repo operations increase liquidity in the system. Reverse repo rate is the rate that RBI offers the banks for parking their funds with it. Reverse repo operations suck out liquidity from the system.

Have there been many changes in these rates, of late?

Ever since monetary tightening started in 2004, reverse repo rate has been raised six times and repo rate seven times. By raising repo/reverse repo rates, the RBI signals interest rate hikes.

How do changes in reserve requirements manifest?

Usually through the CRR (cash reserve ratio), a commonly used measure to influence credit creation and money supply. CRR is the proportion of deposits that banks are required to keep with the RBI.

Which works better: Repo or CRR?

Unlike repo and reverse repo rates, which act as signalling devices, CRR is a blunt instrument that directly acts on liquidity. By raising CRR, the RBI sucks out liquidity from the system and puts upward pressure on interest rates. As a part of monetary tightening, the RBI has raised CRR from 4.5 per cent to 6.5 per cent in recent times.

What does the RBI do when openly operating in the market?

It sells and buys government securities. These activities are called open market operations (OMO). When inflationary pressures exist, the RBI sells securities to mop up excess cash from the system; and vice-versa in case of tight liquidity/shortage of funds.

You mentioned ‘transmission mechanism’. What’s that?

It is the ‘how’ of monetary policy impacting the economy through various channels, directly as well as indirectly.

How?

At the cost of simplification, let us take an illustration. Assume that inflation is rising in the economy and the RBI, to tackle it, decides to signal a rate hike by raising the reverse repo rate. This reduces money supply in the economy as banks are induced to park their cash with the RBI. That puts pressure on the longer term interest rates in the economy — for example, the lending rates for housing, consumer loans, etc. These rates tend to go up.

The impact of RBI actions on longer-term commercial rates also depends on the expectations of financial market participants, which are shaped by both actions and statements of the central bank.

Is there a flip side to controlling inflation?

Continuing the example, higher interest rates discourage consumption and investment, leading to a reduced aggregate demand (GDP growth) in the system. As a consequence of reduced demand, the pressure on inflation eases. The policy objective of reducing inflation is achieved but at the cost of growth. This is often referred to as the growth-inflation trade-off.

How long does it take monetary policy to attain its objective?

Monetary policy impulses do not impact the real sector and inflation immediately but with a lag, which varies across countries and sectors. In economies such as the US, the lag of monetary policy transmission to the real sector is estimated to be around one-and-a-half years. In India, the transmission mechanism of monetary policy and the lags involved are not very well understood.

A difficulty, that is, for the policymakers?

Yes. A better understanding of transmission mechanisms and lags involved with timely availability of data can help the RBI fine-tune the monetary policy and make it more effective. But because of the lags in monetary policy transmission, the central bank has to be pre-emptive in its approach and diffuse inflationary pressures in the early stages.

What other challenges does the conduct of monetary policy face in India?

Apart from the issues related to monetary policy transmission, the huge inflow of foreign capital has complicated the conduct of monetary policy. The capital inflows have increased the supply of dollars, which makes the rupee stronger.

But the RBI keeps buying dollars to check appreciation, doesn’t it?

Yes, and that consequently raises money supply in the process. This is in conflict with its current stance of tightening monetary policy, and necessitates sterilisation operations.

Sterilisation?

It refers to the selling of securities to suck liquidity. The extent of sterilisation depends on the stock of securities with the government available for intervention. The entire process is quite cumbersome. To understand the dilemma faced by the RBI, one needs to bring in the macroeconomic dilemma of ‘impossible trinity’.

What’s that?

It states that a country cannot simultaneously have an inflexible exchange rate, independent monetary policy, and free capital mobility. With massive capital inflows, the RBI is finding it difficult to simultaneously protect the currency and pursue its monetary policy objectives.

Has the RBI spoken of… the difficulty?

Very much. The RBI report on Currency and Finance (2005-06) notes that “the heightened uncertainty surrounding the conduct of monetary policy has obscured a proper assessment of the nature of shocks impacting the economy and the resulting risks to price stability. It has made the interpretation of macroeconomic and financial data difficult”.

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