RBI's Exit Policy

As market expected, before monetary policy review (which is scheduled in 20th April) RBI has raised the short term lending/borrowing rates.

RBI has raised repo & reverse repo rate by 25 basis points from 4.75% to 5% & 3.25% to 3.5% respectively.

Repo is the rate at which RBI lends money to banks & reverse rate is the rate which banks deposit(or rate at which RBI borrows from banks).

This move was expected because,

1. RBI has raised CRR by 75 basis points Jan 2010 monetary policy

2. Headline inflation measured by WPI has reached 9.89% for February 2010 which above RBI's comfortable zone

3. And most important thing IIP (Index of Industrial Production) is clocking 16% for last couple of months which is an early sign of recovery

4. To avoid the over heating of the economy due to cheap money.

But is this move is inevitable? Does RBI hurriedly took the decision? That time will only say.

But yesterday I read an article in Indian Express by Ila Patnaik which says

"Money supply growth is an important indicator of monetary conditions. This has come down from levels of more than 21 percent in July 2009 to nearly 16 percent in February 2010. Traditionally, reserve money grew because RBI was focused on the exchange rate and continually buying dollars. From 26 March 2007 onwards, RBI's behaviour on the currency market has shifted towards greater exchange rate flexibility. In the last year, RBI's purchase of foreign exchange has dropped to near-zero levels. Under this flexible exchange rate regime, the rupee has appreciated from Rs.50 to Rs.45.50. This shift in RBI's behaviour has reduced the pace of injection of rupees into the economy. Another element of the story is low demand for credit, giving slow growth in non-food credit. Putting these elements together, money supply growth has decelerated sharply over 6 months.

In summary, there are two important mistakes in the Indian inflation discourse. The first is the use of year-on-year inflation measurement, which yields information about inflation pressures in the economy with a lag of roughly six months. The second is the notion that RBI can influence inflation by raising rates. What mainstream central banks worldwide can do -- given a well functioning bond market and banking system -- is not feasible for RBI given the crippled bond market and banking system. Mechanically raising rates when inflation goes up is not particularly useful, given the malfunctioning monetary policy transmission.

A more nuanced approach, reflecting an empirical understanding of relationships visible in Indian data, is required. RBI's communications on this subject need to improve, combining a better analytical framework, and an honest treatment of its trading activities on the currency market. Thus for example, if the RBI chooses not to raise interest rates, as they are unlikely have a direct impact on inflation, it should say so clearly, and explain why, describe how a quiet tightening has been taking place and what policy options are being chosen and why. Not doing so results, in general, in a situation like the present one where expectations of rate hikes build up, and RBI comes under pressure from various quarters on its conduct of monetary policy"