Monetary Policy: The <I>stance</I> has changed! - Views on News from Equitymaster

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Monetary Policy: The stance has changed!

Oct 25, 2005

The Reserve Bank of India's mid-term review of the Annual Monetary Policy 2005-06 was announced today. The central bank has raised the reverse repo rate by 0.25% to 5.25%. Since the spread between repo and reverse repo rate has been maintained at 100 basis points, repo rate stands increased by 0.25%. Repo rate is the rate at which banks borrow from the Reserve Bank of India (RBI). In this article, we focus on the stance of the monetary policy and it implications. The STANCE of the Monetary Policy has changed...

Current stance (Mid-term Review of Annual Policy 2005-06)

  1. Consistent with emphasis on price stability, provision of appropriate liquidity to meet genuine credit needs and support export and investment demand in the economy.

  2. Ensuring an interest rate environment that is conducive to macroeconomic and price stability, and maintaining the growth momentum.

  3. To consider measures in a calibrated and prompt manner, in response to evolving circumstances with a view to stabilising inflationary expectations.

Previous stance (Annual monetary policy 2005-06 - April 2005)

  1. Provision of appropriate liquidity to meet credit growth and support investment and export demand in the economy while placing equal emphasis on price stability.

  2. Consistent with the above, to pursue an interest rate environment that is conducive to macroeconomic and price stability, and maintaining the momentum of growth.

  3. To consider measures in a calibrated manner, in response to evolving circumstances with a view to stabilising inflationary expectations

What is different from the earlier stance?

  1. The stance of the monetary policy this time starts with emphasis on price stability i.e. inflation. What this means from a lay-man's perspective is that if inflation rises much higher than the 5% to 5.5% as expected in the Annual Monetary Policy, the RBI will have to raise interest rates. The following is an extract from the mid-term review - "Given the outlook for inflation primarily in the context of the oil economy in India, however, it may be difficult to contain the inflation in the range of 5.0-5.5 percent projected earlier without an appropriate policy response". Clearly, there is a signal towards raising interest rates going forward.

  2. Secondly, there is a change as far as credit demand is concerned. In the mid-term review, the RBI's stance has changed 'to meet genuine credit needs' of as compared to the earlier stance of 'to meet credit growth'. According to the policy "the rising shares of housing and real estate in particular has warranted precautionary policy action to ensure credit quality"

Overall, investors should be prepared for hardening of interest rates in the domestic market going forward. Needless to say that any increase in interest rates will have a negative impact on equity markets i.e. earnings growth of companies and more importantly, valuations. However, we believe that interest rates in the domestic market are unlikely to rise very sharply and to that extent, we do not foresee big worries.

But there is one another factor which equity investors should be worried about i.e. continued rise in interest rates in key economies like the US. The following is an extract from an article by Stephen Roach (24th October 2005) - "I think inflation risks are drifting higher. Thus, we think the Fed will move modestly to restraint, taking the federal funds rate to 5% over the course of 2006".

Interest rates expectations have been revised upwards continuously (from 3% earlier to 4% by the calendar year 2005 to 5% by the calendar year 2006). The recent selling by Foreign Institutional Investors (FIIs) (to the tune of US$ 433 m - October 2005) is a consequence of not only firm interest rates globally but also owing to higher oil prices, which could slowdown economic growth. One will not be surprised of more such actions going forward. The monetary policy clearly emphasizes on ensuring price stability, which is in line with what is happening globally.

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