RBI’s Interest Rate Policy and Durable Liquidity Question

The Reserve Bank of India’s (RBI) monetary policy has emerged as the most critical policy tool in the post-reform period in overall macroeconomic management, particularly pursuing the objective of growth with price stability. The conduct of monetary policy, of course, has evolved over time, with several turns and twists, both with regard to the policy framework and the operating procedure.

The RBI adopted “monetary targeting with feedback” as the monetary policy framework in 1985 guided by the recommendations of the Chakravarty Committee (RBI 1985). The context in which such a framework was adopted needs to be understood. Given the high level of inflation in the 1970s and 1980s, the need for price stability became dominant. The high inflation was fuelled by excessive money supply which was the outcome of large RBI credit to government. With an administered interest structure, money supply became the target variable for achieving price stability. With the development of a broad-based financial market after the freeing of the interest rate and exchange rate in the early 1990s, it became possible to shift focus from exclusive reliance on monetary aggregates for conduct of monetary policy to a broad set of indicators, including interest rates, prices, bank credit growth, foreign exchange rate, balance of payments indicators, etc. Thus, the RBI adopted “multiple indicators approach” in 1998–99. However, it posed all the issues connected with multiple objectives. Subsequently, guided by the recommendations of Patel Committee (RBI 2014), “inflation targeting” became the latest monetary policy framework since 2014–15. This has brought clarity to the objectives of monetary policy.