Understanding of Monetary policy and its relation to inflation

Monetary policy is the process by which the government, central bank, or monetary authority
of a country controls the following factors in order to attain a set of objectives oriented
towards the growth and stability of the economy [1]
(i) the supply of money,
(ii) availability of money, and
(iii) cost of money or rate of interest
The Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy rests on the relationship between the rates of interest in an economy, that is
the price at which money can be borrowed, and the total supply of money. Monetary policy
uses a variety of tools to control one or both of these, to influence outcomes like economic
growth, inflation, exchange rates with other currencies and unemployment. Where currency
is under a monopoly of issuance, or where there is a regulated system of issuing currency
through banks which are tied to a central bank, the monetary authority has the ability to alter
the money supply and thus influence the interest rate (in order to achieve policy goals). The
beginning of monetary policy as such comes from the late 19th century, where it was used to
maintain the gold standard.
A policy is referred to as:
• Contractionary: if it reduces the size of the money supply or raises the interest rate
• Expansionary: if it increases the size of the money supply, or decreases the interest
rate.
Furthermore, monetary policies are described as follows:
• Accommodative: if the interest rate set by the central monetary authority is intended
to create economic growth
• Neutral: if it is intended neither to create growth nor combat inflation
• Tight: if intended to reduce inflation
It is important for policymakers to make credible announcements and degrade interest rates
as they are non-important and irrelevant in regarding to monetary policies. If private agents
(consumers and firms) believe that policymakers are committed to lowering inflation, they will
anticipate future prices to be lower than otherwise (how those expectations are formed is an
entirely different matter; compare for instance rational expectations with adaptive
expectations). If an employee expects prices to be high in the future, he or she will draw up a
wage contract with a high wage to match these prices. Hence, the expectation of lower
wages is reflected in wage-setting behavior between employees and employers (lower
wages since prices are expected to be lower) and since wages are in fact lower there is no
demand pull inflation because employees are receiving a smaller wage and there is no cost
push inflation because employers are paying out less in wages.
In order to achieve this low level of inflation, policymakers must have credible
announcements; that is, private agents must believe that these announcements will reflect
actual future policy. If an announcement about low-level inflation targets is made but not
believed by private agents, wage-setting will anticipate high-level inflation and so wages will
be higher and inflation will rise. A high wage will increase a consumer's demand (demand
pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a
policymaker's announcements regarding monetary policy are not credible, policy will not
have the desired effect.
If policymakers believe that private agents anticipate low inflation, they have an incentive to
adopt an expansionist monetary policy (where the marginal benefit of increasing economic
output outweighs the marginal cost of inflation); however, assuming private agents have
rational expectations, they know that policymakers have this incentive. Hence, private
agents know that if they anticipate low inflation, an expansionist policy will be adopted that
causes a rise in inflation. Consequently, (unless policymakers can make their announcement
of low inflation credible), private agents expect high inflation. This anticipation is fulfilled
through adaptive expectation (wage-setting behaviour); so, there is higher inflation (without
the benefit of increased output). Hence, unless credible announcements can be made,
expansionary monetary policy will fail.
Announcements can be made credible in various ways. One is to establish an independent
central bank with low inflation targets (but no output targets). Hence, private agents know
that inflation will be low because it is set by an independent body. Central banks can be
given incentives to meet their targets (for example, larger budgets, a wage bonus for the
head of the bank) in order to increase their reputation and signal a strong commitment to a
policy goal. Reputation is an important element in monetary policy implementation. But the
idea of reputation should not be confused with commitment. While a central bank might have
a favorable reputation due to good performance in conducting monetary policy, the same
central bank might not have chosen any particular form of commitment (such as targeting a
certain range for inflation). Reputation plays a crucial role in determining how much would
markets believe the announcement of a particular commitment to a policy goal but both
concepts should not be assimilated. Also, note that under rational expectations, it is not
necessary for the policymaker to have established its reputation through past policy actions;
as an example, the reputation of the head of the central bank might be derived entirely from
his or her ideology, professional background, public statements, etc. In fact it has been
argued (add citation to Kenneth Rogoff, 1985. "The Optimal Commitment to an Intermediate
Monetary Target" in 'Quarterly Journal of Economics' #100, pp. 1169-1189) that in order to
prevent some pathologies related to the time-inconsistency of monetary policy
implementation (in particular excessive inflation), the head of a central bank should have a
larger distaste for inflation than the rest of the economy on average. Hence the reputation of
a particular central bank is not necessary tied to past performance, but rather to particular
institutional arrangements that the markets can use to form inflation expectations. Despite
the frequent discussion of credibility as it relates to monetary policy, the exact meaning of
credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is
believed to be the most beneficial. For example, capability to serve the public interest is one
definition of credibility often associated with central banks. The reliability with which a central
bank keeps its promises is also a common definition. While everyone most likely agrees a
central bank should not lie to the public, wide disagreement exists on how a central bank can
best serve the public interest. Therefore, lack of definition can lead people to believe they
are supporting one particular policy of credibility when they are really supporting another.[3]

Monetary policy of India

Monetary policy in India underwent significant changes in the 1990s as the Indian Economy
became increasing open and financial sector reforms were put in place. In the 1980s,
monetary policy was geared towards controlling the quantum, cost and direction of credit
flow in the economy. The quantity variables dominated as the transmission Channel of
monetary policy. Reforms during the 1990s enhanced the sensitivity of price signals from the
central bank, making interest rates the increasingly Dominant transmission channel of
monetary policy in India.

The openness of the economy, as measured by the ratio of merchandise trade(exports Plus
imports) to GDP, rose from about 18% in 1993-94 to about 26% by 2003-04. Including
services trade plus invisibles, external transactions as a proportion of GDP Rose from 25%
to 40% during the same period. Alongwith the increase in trade as a Percentage of GDP,
capital inflows have increased even more sharply,foreign currency Assets of the reserve
bank of India(RBI) rose from USD 15.1 billion in the march 1994 To over USD 140 billion by
march 15,2005.these changes have affected liquidity and

Monetary management. monetary policy has responded continuously to changes in

Domestics and international macroecomic conditions. In this process, the current
monetary operating framework has relied more on outright open market operations and
Daily repo and reserve repo operations than on the use of direct instruments.overight Rate
are now gradually emerging as the principal operating target.

The objectives are to maintain price stability and ensure adequate flow of credit to the
productive sectors of the economy. Stability for the national currency (after looking at
prevailing economic conditions), growth in employment and income are also looked into. The
monetary policy affects the real sector through long and variable periods while the financial
markets are also impacted through short-term implications.

Reserve Bank of India

The Reserve Bank of India (RBI) is the central bank of India, and was established on April 1,
1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The Central
Office is located at Mumbai since inception. Though originally privately owned, since
nationalisation in 1949, RBI is fully owned by the Government of India. It was inaugurated
with a share capital of Rs. 5 Crore divided into shares of Rs. 100 each fully paid up. The
entire share was firstly owned by private shareholders. The government of India held shares
of nominal value of Rs. 2,22,000.
RBI is governed by a central board (board headed by a governor) appointed by the Central
Government of India. The current governor of RBI is Dr. Subba Rao (who succeeded Dr.
Y.Venugopal Reddy in 2008). RBI has 22 regional offices across India. The reserve bank of
India was nationalised in the year 1949.

The bank was constituted for the need of the following:

• To regulate the issue of bank notes

• To maintain the reserves with a view to securing the monetary stability
• To operate the credit and currency system of the country to its advantage

Main Functions
Monetary Authority:
• Formulates, implements and monitors the monetary policy.
• Objective: maintaining price stability and ensuring adequate flow of credit to
productive sectors.
Regulator and supervisor of the financial system:
• Prescribes broad parameters of banking operations within which the country''s
banking and financial system functions.
 • Objective: maintain public confidence in the system, protect depositors'' interest and
provide cost-effective banking services to the public.
Manager of Foreign Exchange
• Manages the Foreign Exchange Management Act, 1999.
• Objective: to facilitate external trade and payment and promote orderly development
and maintenance of foreign exchange market in India.
Issuer of currency:
• Issues and exchanges or destroys currency and coins not fit for circulation.
• Objective: to give the public adequate quantity of supplies of currency notes and
coins and in good quality.
Developmental role
• Performs a wide range of promotional functions to support national objectives.
Related Functions
• Banker to the Government: performs merchant banking function for the central and
the state governments; also acts as their banker.
• Banker to banks: maintains banking accounts of all scheduled banks.
Role of RBI:
Reserve Bank of India performs following roles in order to accomplish it’s obejectives:
• Bank of Issue
• Banker to Government
• Banker’s Bank and Lender of Last Resort
• Controller of Credit
• Custodian of Foreign Reserves
• Supervisory Functions and Promotional Functions
Goals of Monetary Policy
RBI focuses on the following 6 main basic goals of monetary policy:
• Employment
• Economic Growth
• Price Stability
• Interest Rate Stability
• Stability of Financial Markets
• Stability in Foreign Exchange Markets

Role of RBI and how it controls inflation

Monetary and Credit Policy has direct impact on the prices of commodities, inflation and
prevailing interest rates, hence, the overall growth of the economy. After the economic
reforms started in early nineties, although the interest rate determination is market based,
credit policy of RBI determines the direction of movement of interest rates. Thus the policies
adopted will help RBI to contain inflation. Apart from this it also contains norms for banking
and financial sector and the institutions which are governed by RBI like banks, non-banking
financial corporations, primary dealers (money markets) and dealers in foreign exchange
(forex) market. It also contains an economic overview of the recent happenings. The
objective of the policy is to maintain price stability and ensure adequate flow of credit to the
productive sectors of the economy. Stability for the national currency and growth in
employment and income are also considered.

Control Measures
During the start of this calendar year i.e. Jan 09 to Mar09, we have seen RBI using the
following means to control inflation.

• Open Market Operations

• Reserve Requirements

• Bank Rate or Discount Rate

• Repo Rate

Open Market Operations (OMO)

In this case RBI sells or buys government securities in open market transaction depending
upon whether it wants to increase the liquidity or reduce it. So when RBI sells government
securities in secondary market it removes the liquidity from the economy. So overall it
reduces the surplus money available with banks there by reducing the capital available with
banks for lending purposes. Because of the availability of cheaper cash becomes dearth the
interest rates start moving upward. Similarly when RBI buys government securities in the
secondary market it infuses money to sellers of the bonds. Since this can bring down the
bond holdings with banks and improve their liquid cash availability. This condition leads to
aggressive reduction of interest rates by banks to improve the customer base. This results in
business activities like new investment and capital expansion to boost.

Reserve Requirements:
This mainly constitutes of

• Cash Reserve Ratio (CRR)

• Statutory Liquidity Ratio (SLR).

CRR: is the portion of deposits which banks have to keep/ maintain with the RBI. This
serves two
purposes:
• It ensures that the portion of banks deposits is totally risk free
• It enables RBI control liquidity in the system

SLR: is the portion of deposits which banks are required to invest in the government
securities.
Due to the presence of these requirements and since RBI being the banker to the banks, all
the banks are obliged towards these requirements. This will lead to financial institutions
being able to lend only the part of the money available with them. But because of the money
flow in our economy happens in layers, by the time money reaches to the people at the
bottom of the pyramid the amount of money left is generally very less. Higher the CRR,
lesser is the money available with the people in the economy. This leads to increased
demand for money and would in turn result in increase in the interest rates. And similarly
when the CRR is reduced the effect in-turn results in reduction of interest rates in the
economy.

Recently RBI raised CRR from xx% to xxx% in xxxx stages. CRR has been gradually
coming down over the years i.e. from 15% in 1981 to xx% in 2009.

Bank Rate or Discount Rate

This is the rate at which RBI makes very short term loans to banks. Banks borrow from RBI
to meet any shortfall in their reserves. An increase in the discount rate implies that RBI
wants to slow the pace of growth to reduce inflation. A cut means that RBI wants the
economy to grow and take up new ventures. Bank rate has been gradually falling over the
years. It used to be around 10% in 1981 which increased to around 12% in 1991, but from
then on it came down to around 6% in the present context.

Repo Rate
It is the rate at which RBI borrows short term money from the market. After the economic
reforms RBI started to borrow at the market prevailing rates. So, banks have shown
increased interest in parking their money with RBI since their money is risk free. The repo
rate transactions are generally for a very short duration, the magnitude of the transactions on
a daily basis is to the tune of Rs. 40000 crores. An increase in repo rate would lead to
banks shifting more liquid money towards RBI and if repo rates decrease banks will be
reluctant to park money at place where the returns are smaller.

Since there is a limitation to the open market transactions and given the almost fixed nature
of Bank Rate, RBI can employ CRR, SLR and Repo rate as its main instruments to change
the liquidity levels in the economy and thereby reducing the price variations in the economy.

Historical effectiveness of RBI’s actions on inflation

The average inflation rate in India has been around 8 per cent per annum over the last three
decades. A decade wise comparison reveals that the inflation rate has been quite stable: it
averaged 9.0 per cent per annum during the 1970s, 8.0 per cent during the 1980s and was
8.1 per cent during the 1990s. Since the latter half of the 1990s, however, there is a
perceptible lowering of the trend inflation, abstracting from the supply shocks. The current
low inflation reflects both demand and supply factors; accordingly, periods of low inflation for
a year or so may not break public’s inflation expectations, given the role of adaptive
expectations. Moreover, recent monetary policy statements have projected indicative targets
for money supply based on an assumption of the inflation rate in the vicinity of 5% by March
2010. Against this background, the costs of a further permanent reduction in inflation rate to
the levels prevailing in industrialised nations may need careful consideration. Furthermore,
the edging down of trend inflation suggests a flattening of the aggregate supply curve in
India as in many other countries bound by the downturn. The stance of monetary policy in
India has been accommodative with policy interest rates at their three decade lows. There
are indications that the inevitable tightening of monetary policy to stabilise the upturn will be
postponed well in to latter half of third quarter FY10.

The above graph show that over the past 35 years the rate of increase of inflation and also
the Real GDP growth rate. This graph clearly shows that, sometimes the inflation rate has
spiked up to double digit, but the RBI has been able to bring it to around 5% acceptable
inflation each and every time. This shows that RBI has been keenly effective with its
monetary policy, and has been successful in controlling credit supply to check inflationary
and deflationary concerns.

Inflation and monetary policy in India in recent timeframe

Two months ago the market was marked with flavour of positive economic indicators. The
sentiments have even been reflected on the stock markets. This is due to strong numbers of
Industrial Output Data for August 2009 which stood at 10.4%. This kind of growth rate was
seen only 2 years ago. Despite the visible economic growth, Prime Minister’s assurance that
the economic stimulus would continue also had its effect on the market sentiment.

Inflation (WPI) rose to 0.92 percent from around 0.7 percent a week ago. Though the
inflation numbers have shown a marginal increase in overall prices as compared to last year,
the prices of non-processed food items were higher by around 13% in October compared to
same week last year. The Prime Minister’s Economic advisory council expects the inflation
to rise above the projected 5% by the end of this fiscal year. This shows that we can expect
early actions from RBI on the monetary front

Countries that follow a planned inflation targeting policy focus on core inflation, not on
headline inflation, which is exaggerated due to supply shocks. Given the structure of a
developing economy like India, inflation of 6-7% is inevitable, particularly when the economy
is in a recovery phase
In lines with what has been said above, RBI is reluctant to act on the existing scenario where
the food inflation has reached a 10 year high of around 19%. RBI still feels that the existing
food inflation is due to the supply crisis resulted due to the bad monsoon season this year.
And also given the lower acreage of cultivation of food crops by farmer has added fuel to the
fire. If the coming year turns out to be a good year with reasonably good monsoon season
and increased area under cultivation motivated by improved MSP set by the government, the
supply is set to improve bringing down the prices.

The existing situation is the one where the growth is returning back to its previous levels
driven both by the increased aggregate demand and also driven by the government
investments. The inflation (WPI) which has touched 0 sometime this July has again returned
to the positive territory last October. Given the situation of excessive liquidity in the economy
and spiralling food prices and also the supply shock because of lower rainfall and the impact
of floods in the food grain producing areas, RBI needs to think carefully before taking any
kind of liquidity freezing decision.

The soft fiscal measures if taken to abate inflationary pressures will result in a significant
loss to the Exchequer. This leads to widening of the fiscal deficit which is undesirable and
also brings additional pressure in the market. Hence, there will be a spiralling impact, where
in the interest rates will be on the rise. The widening fiscal deficit and even the growing
interest burden will worsen the already widened and will lead to unsustainable fiscal
scenario. Moreover, any attempt to further issue infrastructure-financing bonds for prudent
use of foreign exchange reserves will increase the outstanding interest bearing government
liabilities and hence the interest burden. This will widen the revenue deficit. The government
must be aware of this situation as it has already raised money by the issue of bonds worth
Rs. 200000 crores. With all this money in the system the short term inflation is bound to rise
given the turnaround in demand. Therefore we observe that the short term inflation
management policy doesn’t seem to be consistent with the long-term policy of ensuring fiscal
rectitude as mandated in the Fiscal Responsibility & Budget Management Act (FRBM).

Second Quarter Review of Monetary Policy 2009-2010

The following issues are brought to the notice.

“The decline in WPI inflation from a peak of 12.9 per cent in August 2008 coincided with
the moderation in economic growth, thereby creating space for the adoption of an
accommodative growth supportive monetary policy stance, which has continued in
2009-10 so far.”

“The emerging inflationary pressures are clearly visible in terms of the increase in WPI by
5.9 per cent over its end-March level as well as high and rigid CPI inflation.”

“The changing inflation environment is being driven by high order of price increases in
essential commodities, particularly in items of mass consumption like vegetables, pulses
and sugar.” Chart V1.1, below, shows the CPI (consumer price index) for few Asian
economies.

“The dominance of the food price inflation is evident from the fact that inflation in WPI (y-o-y)
excluding the food category remains significantly lower at (-) 3.4 per cent, as against the
headline inflation of 1.2 per cent as on October 10, 2009. Given the nature of the sources of
emerging inflation, sustained policy emphasis on improving both supply conditions
and supply chain for distribution would be necessary.”

In the above chart, we can also see that in the advanced economies except Japan the CPI
was around 2-4% during May 07.

The Wholesale Price Index (WPI) has also extremely high in almost all the economies; this
was primarily driven by higher commodity prices. The oil prices spiralled up from $ 50 per
barrel in December 2006 to around $ 150 per barrel in December 2007.

The spike in crude oil prices has been followed by increased transportation costs, other
metal prices etc. Since the overall raw material prices increased substantially the inflation
shot up to unmanageable levels.
But, once the inflated bubble has burst triggered by the housing market crash in the US and
the bankruptcy of various investment banks and general banks; leading to huge losses being
incurred by banks which took leveraged positions has tightened the credit availability in the
international market. This sudden fall in credit supply has lead to the liquidity crisis of several
companies which in turn lead to job being terminated, salaries being reduced and resulted in
overall reduction in aggregate demand.

As far as Indian market is concerned, the non availability of credit in the international market
has lead to set back for many companies in India which had budgeted capital for expansion
purposes. The moderation of growth had taken place because of fall in demand. The credit
supply in India had come down drastically, as banks are unwilling to take risk fearing the
increased trend of Non Performing Assets.

The demand for credit also decreased because of the consumers unwilling to take loans at a
higher interest rates resulted by the increase in the key policy rates in the economy.
Once the demand came down the sky rocketed oil prices too came down tumbling. This is
again followed by the metal prices and all the commodities prices came down and even the
transportation costs came down.
In the emerging economies, inflation eased significantly since July 2008, in line with
decreases in international commodity prices and general slowdown in economic activity
brought about by the global financial crisis. Among the major emerging economies,
consumer price inflation in China and Thailand turned negative in early 2009, while it turned
negative in Malaysia in June 2009; other major economies also witnessed significant easing
in price pressures. Most central banks in emerging economies (except China) reduced their
policy rates in 2009 in an effort to arrest the moderation in growth and to counter the
spillover effects of the global financial crisis.
“The threat that had emerged in the process was disinflation. Major factors that contributed
to the disinflation process include the steep decline in oil prices from the record level in July
2008, large downward corrections in food and metals prices, lower transportation costs and
the existence of significant industrial slackness due to sub-optimal capacity utilisation.
According to the IMF (October 2009), global inflation is expected to remain subdued and
vulnerable to mild deflation. With inflationary expectations remaining generally well-
anchored, risks for sustained deflation are, however, perceived to be small. On the other
hand, inflation risk may be more in emerging economies where output gaps are smaller and
recovery may be stronger”
Given the adverse inflation scenario in the early January of 2008, central banks across the
world had started to act for containing the inflation. The above table shows the basis point
changes in the key policy rates both in developed economies and in the developing
economies. For the table we can see that in India the current Repo rate stands at 4.75 and
Reverse Repo Rate stands at 3.25 and this is arrived at after having reduced the respective
rates by 425 basis points and 275 basis points respectively.

The division of the above mentioned reduction of rates is being show the below given table
format which tells the stance taken by RBI while trying to reduce the liquidity in the economy
to curb inflation till August 2008 and the reversed trend of reducing the interest rates to
tackle the slowdown pressures of the economy. The reduced interest rates have almost
bottomed out in April 2009. After having reached levels where in the credit availability has
substantially improved at least with banking system. And adding to it the complementary
fiscal policy measures where in Govt sold bonds worth more than Rs. 200000 crores has
substantially eased the liquidity pressures of the infrastructure companies in the short term.

Implications

As is obvious from the given data and the figure below, RBI has used monetary policy to
keep the inflation rate within the desired band of 5-6%. Whenever the inflation rate increases
alarmingly, RBI desperately tries some monetary measures which may be through
adjustments of CRR, Repo rate and Reverse Repo Rate. As can be seen in the graph a
cluttering of points around first and second quarter in 2008 indicate desperate efforts by RBI
to curb the inflation (as can be seen that WPI Inflation was hovering above 12%).

Monetary tightening by the central bank will curb prices and affect many sectors of the
economy but the impact usually happens with a delay of up to six months:
In the face a cash shortfall in the banking system, commercial banks are being forced to
borrow from the Reserve Bank to meet growing demand for loans. The raised repurchase
rate should increase the cost for commercial banks to borrow from the central bank, which
will in turn help curb the credit growth. Though the current situation is telling the opposite
story. The RBI aims to improve the rate of credit growth to double digit % from the current 5-
8% levels in order for investment to take place and to improve the aggregate demand.

References:

• Monetary Policy". Federal Reserve Board. January 3, 2006.

http://www.federalreserve.gov/policy.htm.

• B.M. Friedman "Monetary Policy," International Encyclopedia of the Social & Behavioral
Sciences, 2001, pp. 9976-9984. Abstract.

• RBI Second Quarter Monetary Policy Review FY10, release document

• An article on, “HOW SOON MONETORY POLICY CAN TAME INFLATION?” on

Indiamart website

• RBI official website for Inflation and GDP figures for the past 35 years