RBI’s Monetary Policy

Shri Arun Jaitley has again emphasised on RBI to reduce interest rate so that domestic industry which is short of capital can fulfill its requirement. I hope that RBI governor Raghuram Rajan will heed this advice in the coming policy announcement. With strong emphasis on sustainable growth, the RBI in its last bi-monthly policy had left the key monetary policy rates unchanged. The apex bank announced that on the basis of assessment of key current and forthcoming macroeconomic trends, the monetary policy rates should be left unchanged.

The main thought behind such a cautious move is to continue with the current market trend, aiming at moderate inflation. One of the key issues identified by the RBI governor as a long term agenda of the current policy moves was moderate inflation as it fosters sustainable growth in the long term.

Both, the Government and the RBI are currently in discussion to put in place a monetary framework for inflation control in the longer term. Although, neither the RBI nor the government has come out with a time frame, the rough estimate is the first quarter of 2016. This is also the buffer time given to the economy to fall in tune with the government’s new monetary policy framework. An important constituent of this framework estimates to keep the CPI induced inflation around 4% (+/- 2%).

RBI’s steps can be understood in the context of the report submitted by the expert committee, earlier this year, appointed to examine the current monetary policy framework of the RBI, headed by Urjit R. Patel, Deputy Governor of the RBI. Among policy recommendations, the two principal recommendations of the committee included adopting a new CPI as the main aspect around which the discourse of monetary policy as well as the initiatives should revolve, and more importantly setting a long term target to control inflation. The idea behind adopting CPI as the “Nominal Anchor” for inflation has at least two justifications; first, that it is a tried and tested method which has been adopted by most of the economies except China and India and secondly, if the nominal anchor is CPI, the inflation rate can be better monitored as the data for CPI is released roughly every fortnight.

This monetary policy of the RBI is in consonance with the U. Patel committee report, which advised the RBI to focus only on inflation for now. Thus, the current monetary policy of the RBI seems to be directed at controlling inflation, while other growth, employment, exchange rate and price stabilisation are either left to be auto-corrected as a result of these policy initiatives, or deferred for later policy changes.

The new monetary framework that includes CPI as the nominal anchor has potential drawbacks too as more than 50% of the index is dominated by food and fuel commodities. As agricultural output can be rain dependent and oil imports depend on external factors, there is a possibility that the exchange rates are heavily influenced, in turn affecting inflation in India. But as market trends are positive, primarily on the back of increased domestic activity, the RBI seems to have done the right thing in not tampering with the exchange rates.

One of the key factors influencing the RBI’s most recent monetary policy has been a high inflation accompanied by a tight liquidity situation in the country. The RBI kept the bank rates unchanged as it expects the inflation to improve in the coming months on the back of increased domestic activity and increased liquidity. Even as targeting of inflation has become a priority for the RBI, price stability is the long-term goal that would increase domestic demand and hence liquidity. A tight liquidity in the economy could easily lead to banking crisis.

The price stability is another area of concern. The currency market has remained in a flux mainly due to rising external debt. External Debt in India increased to $ 440614m in 2014 from $ 390048m in 2013. According to RBI data, India’s external debt-to-gross domestic product (GDP) ratio has steadily risen from 18% in 2010-11 to 23% in 2013-14. The rate of debt growth has surpassed the growth of forex, resulting in fiscal strain.