The monetary authority, which is the central bank of a country, is vested with the responsibility of conducting monetary policy. The term monetary policy refers to what the central bank does, and the instruments it uses under its control, to influence the amount of money and credit in the economy. What happens to money and credit affects interest rates (the cost of credit) which in turn impacts the performance of the economy.
Depending on the state of the economy, whether it is in a recession or experiencing tremendous growth or is stagnant, the central bank of the country will decide on an expansion or contraction of money supply, or whether to maintain a status quo. Various data points, specifically inflation, play a crucial role.
An expansionary monetary policy expands money supply and boost economic activity, mainly by keeping interest rates low to encourage borrowing by companies, individuals and banks. However, it also risks ramping up inflation. On the flip side, we have contractionary monetary policy which comes into play when the central bank is worried about the economy overheating. Interest rates are hiked to reduce the money supply and curb inflation. The goal is to slow down the pace without pushing the economy into a recession.
The central bank intervenes through various measures - open market operations (the purchase and sale of government securities in the open market by a central bank), reserve requirements for banks and key rates. These in turn will impact interest rates and liquidity in the economy. Most recently, the U.S. central bank – the Federal Reserve, was in the news because rates were left unchanged. The rates have been at the same near-zero level since December 2008.
With the Federal Reserve not hiking rates and the flight of capital having diminished, the possibility of India’s central bank - the Reserve Bank of India, or RBI, cutting policy rates this month-end has increased. Despite being under pressure to cut rates, the RBI Governor has maintained that keeping inflation at lower levels is the key. Besides inflation, the governor has also expressed concern that the earlier rate cuts have not been significantly transmitted throughout the system for the end users to enjoy the full benefits of the rate cuts.
Since January this year, the RBI has cut the repo rate by 75 bps. The last cut lowered the repo rate to 7.25% on June 2, 2015.
The RBI used to announce its monetary policy twice in a financial year. The financial year starts on April 1 and ends on March 31 the following year. After Bimal Jalan took charge as governor in 1997, he moved from two monetary policy reviews in a year to quarterly reviews. His successor Y V Reddy introduced a mid-quarter review, which resulted in an announcement every 45 days. A panel headed by RBI deputy governor Urjit Patel had recommended that the central bank monetary policy committee conduct a bi-monthly review. So while the RBI reviews its stance once in two months, it has the leeway to make changes to policy between the reviews if necessary.
The RBI shall be announcing its next policy statement on September 29, 2015.
