In developed countries monetary policy which is unveiled by the central bank periodically is mainly aimed at keeping inflation low. In India as well as many other developing economies central banks have twin objective of controlling inflation and pushing growth.

It is therefore a balancing act always for Reserve Bank of India, which has to contain inflation without impeding growth momentum, every three months monetary policy review takes place. Of course, central bank can intervene in between if an unusual situation arises warranting policy action.

In the face of global currency crisis in 2008 which blew over into a recession, unprecedented since the great depression of 1928, central banks world over including India had to take swift monetary action to get out of the monumental crisis.

With severe liquidity crunch in the banking system and collapse of several top global banks due to mounting bad debts, policy actions were required to pump-in money into the system so that demand picks up and thereby the plummeting growth, crucial for the health of the economy.

Instead of keeping tight control of money supply and interest rates, central bank adopted easy monetary policy by injecting more money into the system and lowering interest rates which fell to near zero in developed countries to prop up growth that became negative in some countries.

Conservative approach by RBI
Unlike in many other countries, Reserve Bank of India has been conservative in its monetary policy and the Government very cautious in moving towards full float of rupee, that is total capital account convertibility.

This approach helped India to ward off a major crisis and economic recovery from the global recession faster. During the crisis the Government and Reserve Bank had to come out with fiscal stimulus and monetary stimulus packages to revive the economy. This pushed the Government’s fiscal deficit up to 6.7% of GDP (2009-10) due to increased spending, leading to high borrowing.

Reserve Bank’s Monetary policy became very accommodative releasing more cash into the system and lowering key policy rates to reduce interest rates so as to ensure that cost of borrowing is less.

The monetary instruments that the central bank used for this purpose are Cash Reserve Ratio (CRR), the percentage of money, the slice of deposit that banks have to park with the central bank and the key short-term policy rates, Repo and Reverse Repo rates. (Repo is the rate at which banks borrow overnight or short-term from the Reserve Bank. Reverse Repo rate is the rate at which banks deploy surplus funds with the central bank.)

With large capital flows from abroad and increasing domestic demand for investment funds, there was increased borrowing before the global crisis and the central bank had increased Cash Reserve Ratio to as high as 9% in a grade manner to suck out excess liquidity in the banking system so that there was no overheating of the economy, particularly through increased lending to real estate sector where a bubble was in the making.

Likewise it increased repo and reverse repo rates in stages and repo rate was as high as 6% to ensure cost of funds for lending become expensive for banks.

Easy monetary policy during global crisis
When the global recession started, central bank started adopting accommodative monetary policy, making available more liquidity in stages and reduced the cost of borrowing. CRR came down to as low as three per cent and Repo rate to nearly 4 per cent. This released more than 3 lakh crore into the banking system so that there was ample liquidity available to prop up growth.

With the economic recovery and surging inflation, unwinding of the easy monetary policy and fiscal stimulus began in a calibrated manner in the last few months. Monetary tightening began in January to ensure excess liquidity is sucked out in a graded manner to contain inflation without impeding growth momentum as economic recovery is still fragile.

Exit from easy policy began with recovery and inflation surging
To tackle rising inflation, the central bank in its annual monetary policy statement for 2010-11 unveiled on April 20 raised key policy rates – repo and reverse repo rates for second time in as many months and CRR to squeeze out excess liquidity from the banking system.

The Repo and Reverse Repo rates were hiked by 0.25 % and CRR too by 0.25% to take away Rs 12,500 crore from the system. An increase in policy rates signals a rise in interest rates. Repo rate will now be 5.25% while Reverse Repo rate will be 3.76%.

The CRR hike which will come into effect on April 24 will now be 6%. Earlier in January during the quarterly policy review, the central bank had raised CRR by 0.75% to 5.75% to suck out Rs 37,500 crore liquidity from the banking system.

Reserve Bank Governor, Dr. D Subbarao rightly said after the policy announcement that he would like to take "baby steps" which was better for the economy as drastic hike in policy rates and CRR might have helped in bringing down rapidly but would hit hard the growth that is beginning to look up.

Inflation still a matter of concern
Inflation no doubt is a matter of concern as food inflation has started spilling over to non-food areas. But a small dose of inflation is good for the economy as it has multiplier effect thus helping the pace of recovery.

"We believe that taking several baby steps towards normalisation is better for the economy to adjust with the pre-crisis growth level," Dr. Subbarao said. These baby steps might not immediately affect lending rates of banks as there is still enough liquidity in the system as demand for credit is picking up slowly.

Dr. D Subbarao said he would not like to take mid-policy action before July end, when the quarterly policy review will be unveiled. He pegged the inflation to be at 5.5% in 2010-11 and the growth to pick up to 8% in the financial year.

He said it was therefore important to calibrate the exit from the easy policy stance, given the revival in demand for credit and the large Government borrowing programme. He expected credit growth of 20% this year.

Endorsing the measure, the Finance Minister Shri. Pranab Mukherjee described it as "well-balanced and mature" and this "gentle’ and "small tightening of credit" will dampen further inflationary pressures.

He even disagreed with Reserve Bank forecast of 5.5% inflation this year saying analysis showed that the Inflation may come down further and it could be even close to 4%.

Inflation to come down further
Food prices have already started falling with the arrival of rabi crop. The Finance Minister said overall inflation has peaked and should be on a downward trajectory from now on. There was nothing untoward happening on the weather front this year to warrant fear of food prices going up again.

With the economy now being stable and on track, " I view these changes as a move to normal times," Shri. Pranab Mukherjee said assuring there was no need for any worry that squeezing of credit will not dampen growth especially in the durable goods sector.

"Our analysis of industrial growth and credit off-take suggests that there is no reason for such apprehension (of impeding growth). In fact, these policies will aid sustainable growth," The Finance Minister aptly summed up the monetary measures taken by Reserve Bank.

*K R Sudhaman is a freelance writer.
*The views expressed by the author in this feature are entirely his/her own and do not necessarily reflect the views of SME Times.