First Quarter Review of the Monetary Policy for 2010-11
-Announced on the 27th July 2010
III. The Policy Stance
48. Since October 2009, when it signalled the reversal of its policy stance, the Reserve Bank has cumulatively raised the CRR by 100 basis points and the repo and reverse repo rates under the LAF by 75 basis points each. The monetary policy response has been calibrated on the basis of India’s specific growth-inflation dynamics in the broader context of persistent global uncertainty.
49. Thus, our policy stance for 2010-11 has been conditioned by three major considerations:
50. First, domestic economic recovery is firmly in place and is strengthening. The 7.4 per cent growth in 2009-10 despite weak global growth and the insignificant contribution of the agriculture sector is a testimony of the resilience of the Indian economy. The Reserve Bank’s upward revision of the GDP growth projection for 2010-11 to 8.5 per cent (from 8.0 per cent with an upside bias in April 2010) indicates that the economy is steadily reverting to its pre-crisis growth trajectory. However, even as this is happening, prospects of a sustained global recovery appear to be increasingly uncertain, with possible adverse consequences for the EMEs, including India.
51. Second, inflationary pressures have exacerbated and become generalised, with demand-side pressures clearly evident. Capacity constraints are visible in several sectors and pricing power is returning to producers. Inflationary expectations also remain at an elevated level. Given the spread and persistence of inflation, demand-side inflationary pressures need to be contained.
52. Third, despite the increase in the policy rates by 75 basis points cumulatively, real policy rates are not consistent with the strong growth that the economy is now witnessing. As articulated in previous policy statements/reviews, lower policy rates can complicate the inflation outlook and impair inflationary expectations, particularly given the increased generalisation of inflation. It is, therefore, imperative that we continue in the direction of normalising our policy instruments to a level consistent with the evolving growth and inflation scenario, while taking care not to disrupt the recovery.
53. In this consideration, the liquidity situation plays a crucial role. It is well understood that transmission of monetary policy through rate actions works most effectively when liquidity is being injected into the financial system by the central bank, rather than when it is being absorbed. Our calibrated actions to absorb surplus liquidity from October 2009 onwards were reinforced by market conditions, which evolved in early June 2010 and still persist. Consequently, overnight call money interest rates have moved towards the upper bound of the LAF corridor, which is equivalent to effective tightening of rates by 150 basis points. This has also brought the system closer to a point at which policy rate actions are likely to have greater traction.
54. Current market conditions indicate that while liquidity pressures will ease, the system is likely to remain in deficit mode for now. This implies a significant change in the monetary operations, which has a direct bearing on our actions. In a deficit liquidity mode, the repo rate under the LAF has emerged as the operating policy rate. The LAF operates in such a manner that as systemic liquidity alternates from surplus to deficit, even at the margin, the overnight call money rates alternate between the reverse repo rate and the repo rate. This imparts volatility to call rates to the extent of the width of the LAF corridor.
55. There is no unique way to determine the appropriate width of the policy interest rate corridor. But the guiding principles are: (i) it should be broad enough not to unduly incentivise market participants to place their surplus funds with the central bank; (ii) it should not be so broad that it gives scope for greater interest rate volatility to distort the policy signal. The challenge, therefore, is to strike the right balance.
56. As the systemic liquidity transits from an uni-directional surplus mode to a bi-directional mode, it will have implications for the effectiveness of monetary transmission. In the context of the changing liquidity dynamics, the operation of the LAF needs to be studied. Accordingly, it is proposed to set up a Working Group to review the current operating procedure of monetary policy of the Reserve Bank, including the LAF.
57. Against the above stated backdrop, the stance of monetary policy is intended to:
Contain inflation and anchor inflationary expectations, while being prepared to respond to any further build-up of inflationary pressures.
Maintain an interest rate regime consistent with price, output and financial stability.
Actively manage liquidity to ensure that it remains broadly in balance so that excess liquidity does not dilute the effectiveness of policy rate actions.
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