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Monetary Policy: RBI's carrot and stick approach - Views on News from Equitymaster
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  • Oct 29, 2013

    Monetary Policy: RBI's carrot and stick approach

    Against the backdrop of sticky inflation, the Reserve Bank of India (RBI) raised its key policy rate second time in a row in nearly as many months. The repo rate or the rate at which the central bank lends money to commercial banks has been raised from 7.5% to 7.75%. This rate hike comes despite the sluggish economic growth prevailing for quite some time now. However, the RBI opines that curbing inflation and inflationary expectations stand critical and will go a long way in restoring growth environment. That said, other measures such as reduction in marginal standing facility (MSF) rate and no change in the cash reserve ratio (CRR, 4%) has brought some respite. The MSF or the rate at which the banks borrow funds overnight from the RBI against government securities has been cut down by 0.25% to 8.75%. Thus while on one hand the RBI tightened liquidity it also offered some ease on short term liquidity needs.

    Economic situation

    Thanks to the upsurge in fuel and food prices, India's annual inflation jumped to 6.5% in September 2013 for the fourth month in succession. This stands way higher than the RBI's comfort zone of 5%. Retail inflation has also risen sharply and is expected to remain above 9% levels going forward. Clearly, this warrants a rate hike. While the RBI continues to battle inflation, economic growth continues to remain a laggard. But it's not just the high rates to be blamed. The industrial activity in the country remains weak. This has hampered the growth in consumer durables (consumption) and capital goods segment (investment). That said, the apex bank foresees revival in growth in the second half of FY14 and estimates the GDP growth rate for the fiscal at 4.8%.

    Strong exports growth and improved growth in services sector coupled with expected pick-up in agriculture will help revive the economic growth going ahead. The RBI is hopeful of the improved investment climate on the back of the revival of stalled projects and the pipelines cleared by the Cabinet Committee on Investment. On the positive side, the external sector has shown signs of improvement. Revival in exports and contraction in import demand for certain non-oil products led to narrowing of current account deficit. This in turn brought stability in the foreign exchange market as well. Subsequently, the RBI could roll back liquidity tightening measures and infuse liquidity into the system through MSF.

    The way forward

    There are meager chances of softening of inflationary risks; given that the food price inflation today stands at 38-month high. Therefore, the challenging times continue to persist for RBI. Investment is key to invigorating growth in the country, and the RBI has tried to improve investment sentiment by cutting interest rates in the past. But the stubbornly higher inflationary scenario continues to force RBI to adopt hawkish stance. Hence, plausible rate hikes going forward cannot be ruled out.

    For individuals and corporates, the near term outlook on interest rates suggest that cost of funds will continue to remain on the higher side. Unless the RBI achieves some degree of comfort on inflation front, liquidity easing measures will at best be cosmetic. Thus excess leverage remains a key risk.



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    2 Responses to "Monetary Policy: RBI's carrot and stick approach"


    Nov 29, 2013

    The RBI intends to curb inflation at any cost even if it means slowing growth.With inflation being high the real rate of return in negative.This is certainly a wise move.



    Nov 10, 2013

    I do not agree with RBI's Monetary Policy of enhancing the interest Rates. These did not work in the last 2 1/2 years to curb Inflation and they are not going to work in future as well.The Governments at Centre and in states must undertake supply and Administrative measures to curb Inflation, especially Food Inflation, which has absolutely NO LINKAGE what so ever with RBI prescribed Interest rates. What is happening is - interest rates essentially represent cost of capital and cost of working capital, which is now several times more in India compared to western countries. But, profitablity, which is the difference between selling rate and cost of capital + working capital is very Low in India. Therefore, even Indian entrepreneurs have stopped investing in India. This was said by the FM also. So, where from FDI will come to India? RBI Rates must come down to support Growth. In respect of Inflation, Government only must act to improve supplies and prevent hoarding. If Inflation does not come down and if RBI goes on increasing interest Rates on that excuse, it would be tragic for Growth of the country

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