Vidya Mahambare: Actions full of sound and fury...

It takes nearly two years to feel the full impact of monetary policy changes on inflation.

As per the latest data released, the year-on-year wholesale price inflation was 5.95 per cent for the week ended January 13 compared to 4.2 per cent a year ago. Given that inflation has once again crossed the RBI's target range of 5 to 5.5 per cent, the RBI's forthcoming move on monetary policy is widely expected to be contractionary. Some, however, believe that such a policy stance is not warranted at this stage given four rate hikes and two CRR increases over the past year. As a backdrop to the impending monetary policy review, this article assesses the monetary policy framework and transmission mechanism in India, that is, how monetary policy is implemented and how monetary impulses are transmitted to the rest of the economy.

The overriding objective of the RBI's monetary policy is to maintain price stability although the relative emphasis between price stability and output stability varies depending on the underlying state of the economy. To achieve these objectives, the RBI relies on a number of instruments. However, since adopting the multiple indicator approach in 1998, the RBI has, in general, relied less on direct (quantity based) instruments such as CRR and SLR for signalling policy stance and more on indirect (price based) instruments such as the repo rate/reverse repo rate. 
   

WEAKENING TRANSMISSION Impact of RBI policy changes on bank interest rates
Table 1: Recent Policy Changes
Bank  Rate		Cash Reserve Ratio		Reverse Repo Rate		Repo  Rate
Rate	Effective date	Rate	Effective date	Rate	Effective  date	Rate	Effective date
6.00	30-Apr-03	4.75	18-Sep-04
		5.00	2-Oct-04
				4.75	27-Oct-04
				5.00	29-Apr-05
				5.25	26-Oct-05	6.25	26-Oct-05
				5.50	24-Jan-06	6.50	24-Jan-06
				5.75	9-Jun-06	6.75	9-Jun-06
				6.00	26-Jul-06	7.00	26-Jul-06
						7.25	31-Oct-06
		5.25	26-Dec-06
		5.50	6-Jan-07

How does a change in policy instrument affect these goal variables? Official interest rate decisions initially affect short term money market interest rates by influencing liquidity in the system. Changes in the market interest rate in turn influence the long term interest rates via the term structure. However, the direction of change depends on how policy changes influence expectations about future interest rates and inflation. It is the long term rates that ultimately influence consumption, saving and investment decisions. Also, changes in market interest rates influence the prices of bonds and equities as well as physical assets such as housing and real estate. This, in turn, provides an additional channel of transmission (wealth effect) by stimulating consumption and investment spending, thereby affecting aggregate spending in the economy. 
 

Table 2: Benchmark PLR changes since 2004 (in per cent)
SBI		HDFC		ICICI
Rate	Effective date	Rate	Effective date	Rate	Effective date
10.25	29-Dec-03
		11.00	Jan-04
				10.50	17-Nov-04
				11.00	09-Feb-05
				11.25	03-Jan-06
				11.75	13-Feb-06
				12.75	14-Mar-06
10.75	29-Apr-06
		11.50	14-Jun-06	13.25	12-Jun-06
11.00	2-Aug-06
11.50	27-Dec-06	13.00	20-Dec-06	13.75	18-Dec-06
Source: Complied by Crisil Research

Moreover, any change in the official rate takes time to have its full impact on the economy. In some cases, it may be several months before higher official rates affect the payments made by some type of borrowers such as home loan-holders (or received by deposit-holders). It may be even longer before changes in their loan repayments (or higher interest income from savings) lead to changes in their spending habits. Empirical evidence suggests that on average, it takes up to about one year for the response to a monetary policy change to have its peak effect on demand and production, and that it takes up to a further year for these activity changes to have their fullest impact on the inflation rate.

How well does the transmission mechanism work in India? The RBI manages liquidity through Liquidity Adjustment Facility (LAF) and Market Stabilisation Scheme (MSS). The LAF was started as a tool to manage daily liquidity mismatch. However, when foreign capital inflow began to rise in 2002 and the RBI's intervention aimed at curbing rupee appreciation started creating surplus liquidity, the burden of sterilisation started falling on the LAF due to the depletion in the stock of G-sec. In response, a new facility in the form of MSS was started in April 2004 to absorb excess liquidity. The objective was to use LAF for daily liquidity management and use MSS along with Open Market Operations (OMO) to manage sterilisation operations.

Although MSS was designed for the purpose of sterilisation, evidence suggests that the extent of sterilisation (as reflected in the absorption of liquidity) via this scheme has declined in recent years in spite of significant foreign portfolio inflow. For instance, over the period April to September 2006, less than half of the accretion to the RBI's foreign exchange reserves were sterilised via MSS. The surplus liquidity thus created has in turn reduced the reliance of commercial banks on the RBI for funds.

In contrast, when tight liquidity conditions prevail, the banking sector once again seems to rely less on the RBI, instead, preferring to borrow in the money market. For instance, the share of LAF in total market liquidity (calculated as the sum of the value of transactions in market repo, Collateralised Borrowing and Lending Obligation, call and absolute daily LAF outstanding) was 62 per cent in August 2006 when market liquidity was at its highest. By December, this share had fallen to 1.7 per cent as market liquidity declined sharply. Indeed, when tighter liquidity conditions prevailed in December 2005 and again in December 2006, money market rates breached the repo window as the banking sector relied heavily on the call money market for funds.

Given that the banking sector is relying less and less on the RBI for funds, it is not surprising that policy changes do not have any immediate impact on banks' lending and deposit rates. For instance, among the three main banks, only ICICI hiked the Benchmark Prime Lending Rate (B-PLR) in 2004 and 2005 following a CRR and reverse repo rate hike in October 2004. Neither SBI nor HDFC changed their B-PLRs for almost two and half years until the hike in April and June 2006, respectively. None of the banks increased their rates after the October increase in the repo rate until the CRR hike was announced in December 2006. The SBI, the largest bank in terms of the share of bank credit, is the most cautious in raising the rate with the current B-PLR more than 2 percentage points below the ICICI B-PLR. Although most of the bank lending takes place below the B-PLR rate and these effective lending rates were increased from time to time on selective loans, the general unwillingness to change lending rates in response to a policy change has undermined the transmission mechanism. In this regard, intrusions from the finance ministry directing public sector banks not to follow suit, in response to an interest rate hike, are not helpful either. Such intrusions undermine RBI's autonomy and increase uncertainty of the effect of policy on goal variables.

To sum up, the review of monetary transmission mechanism in India suggests that the interest rate channel of the monetary transmission is still not working effectively. This in turn explains the RBI's recent decision to switch back to quantity based instruments, such as CRR, thereby implicitly admitting that the transmission mechanism is weak.

The author is an economist with CRISIL Ltd