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Posted by: Deepa Vasudevan on Wed, Oct 1st, 2014

The Importance of the September 2014 Monetary Policy

The RBI issued its fourth monetary policy statement on September 30, 2014. Interest rates and reserve ratios were left unchanged. Liquidity provision through repos of varying maturities continues as before. The only policy change was a reduction in export credit refinancing limits. The status quo review was widely expected; and more or less discounted by markets.  Yet, it would be incorrect to conclude that the monetary policy made no changes. In fact, it made three important points, each of which will greatly influence policy decisions in the discernible future.


First, the RBI has been brutally forthright about the much-discussed decline in retail inflation. It has pointed out that the main reasons for inflation coming off are disinflation in transport and communication costs, along with some tempering of vegetable prices. Even better, it anticipates the downward pressure from a favourable base effect in the next quarter: in October-December 2013, CPI inflation was at a steep 10%-11%; accordingly the year-on-year inflation for those months in 2014 will be pulled down. By declaring that it will “look through base effects”, the RBI has curbed any speculation that may arise simply on the basis of a statistical illusion of low inflation.  


Second, the goal posts of monetary policy have been gently but firmly shifted to January 2016. According to the new inflation targeting regime, RBI is expected to achieve an inflation of 8% by January 2015 and 6% by January 2016. The first target looks feasible now, but the next one will not be easy. Many uncertainties- both international and domestic- have to be navigated in the next 15 months. The end of QE by the US Federal Reserve, a potential slowdown in Europe and Japan,  lower growth in China, disturbances in the Middle east, and chances of a resumption of investment and growth in India- all these developments will have repercussions for monetary flows and inflation, most of which cannot be predicted or handled at this point. However, the RBI can work on managing inflationary expectations by signalling that it will stay on course to meet its inflation targets. By looking forward to the next, tougher target, the policy signals a clear fight against inflation.


Finally, by explaining why growth in non-food credit has fallen to below-10% levels in recent weeks, the governor has effectively silenced those who were using declining bank credit to ask for an interest rate cut.  Some of the fall in bank lending is simply due to a base effect, and some of it is because several corporates have switched to non bank sources of finance, including overseas debt. These are financial decisions taken by industry based on relative costs of borrowing and market conditions, and they should not affect policy decisions.  It is worthwhile to learn from the recent experience of the European Central Bank: despite imposing a penalty for keeping funds with ECB and offering generous refinancing for lending, there is a great reluctance to lend to industry in the midst of a slowdown. Ultimately banks lend only when there are sound projects to invest in; therefore, kick starting demand by creating a favourable investment environment is the best way to increase bank credit numbers.


In the coming months, the key actions to expect from the government are:  supply side reforms to rein in inflation, a consistent check on fiscal deficits, and measures to revive the investment cycle to spur a revival in credit. The RBI is trying to fulfil its mandate by controlling inflation; its ability and willingness to support growth with lower rates of interest depends on these developments.

Akshay K Jani on Sat, Oct 4th, 2014 12:05:34 pm

I have found RBI mindset High interest rate-low liquidity-low spending-declining inflation I think my out of the box mindset is Low interest rate-more borrowing-more production-more supply-declining inflation

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