Monetary Policy

In the annual monetary policy statement the Reserve Bank of India (RBI) was prudent in not touching the key interest rate. An increase in the interest rates would have triggered (a) a rise in the exchange rates, and (b) a fall in the stock prices. The RBI has thus blocked the interest rate channel, the exchange rate channel and the asset price channel of monetary transmission mechanism. The only channel which remains open is the credit channel, which, it is hoped will be more than effective in achieving the targeted 5 per cent inflation mark, without compromising on investment and growth.

A given monetary policy reaches its final objective of price stability and growth via four channels, i e, (a) interest rate channel, (b) exchange rate channel(c) asset price channel, and (d) credit channel. While targeting a lower inflation rate and a higher growth rate, the RBI has very prudently left the interest rates untouched. In an era of market determined interest rates, the RBI uses the repo rate as the “signal rate”, to which all key interest rates of importance are linked. But raising interest rates attracts capital inflows, due to increased interest rate differential between India and other countries. This will put upward pressure on the rupee which will appreciate and further adversely affect exports. Thus the policy of not raising interest rates not only plugs the capital inflow, but also takes care that exports are not adversely affected via the exchange rate channel. Also, with escalating international food and fuel prices, this measure will act as a buffer to the fragile balance of payments. Thus, banking on the interest rates for inflation control would have been a short-sighted option.