ABOUT MONETARY POLICY Monetary policy is the macroeconomic policy laid down by the central bank.

It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity. In India, monetary policy of the Reserve Bank of India is aimed at managing the quantity of money in order to meet the requirements of different sectors of the economy and to increase the pace of economic growth. The RBI implements the monetary policy through open market operations, bank rate policy, reserve system, credit control policy, moral persuasion and through many other instruments. Using any of these instruments will lead to changes in the interest rate, or the money supply in the economy. Monetary policy can be expansionary and contractionary in nature. Increasing money supply and reducing interest rates indicate an expansionary policy. The reverse of this is a contractionary monetary policy. ABOUT REPO RATE Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds. Repo rate is used by monetary authorities to control inflation. It is an instrument of monetary policy Effects of Repo rate on Inflation When the repo rate is raised, banks are compelled to pay higher interest to the RBI which in turn prompts them to raise the interest rates on loans they offer to customers. The customers then are dissuaded in taking credit from banks, leading to a shortage of money in the economy and less liquidity. So, while on the one hand, inflation is under controlled as there is less money to spend, growth suffers as companies avoid taking loans at high rates, leading to a shortfall in production and expansion. For instance, if the availability of funds is scarce, and banks are not able to borrow at repo rate, they may have to increase the deposits rates upwards to attract depositors. Hence, any rate hike in repo rate increases the probability of higher deposit rates, which is good news for depositors.
Impact on Sectors Sectors such as automobiles, consumer durables and realty are the most vulnerable in the scenario where policy rate hikes push the interest rates. Rising rates would not only reduce the demand for these companies products, they will also affect their earnings in terms of rising interest costs. Rising rates would also impact companies with higher leverage. Besides, there is a possibility that more money gets allocated to debt than equities given the risk-return tradeoffs.

Reserve Bank Governor Raghuram Rajan (28th january

2014) surprised the markets

by raising key policy rate by 0.25 percent to 8 percent in a bid to curb inflation, a move that may translate into higher EMIs and push up the cost of borrowing for corporates. The RBI's Macroeconomic and Monetary Developments report released today said that over the next 12 months retail inflation will continue to remain over 8 percent level. Reserve Bank of India governor Raghuram Rajan last week called inflation a "destructive disease" that was forcing the bank to keep interest rates high. A panel formed by Reserve Bank of India (RBI) Raghuram Rajan has suggested that the central bank focus primarily on managing inflation, switching to consumer prices from wholesale prices in setting its inflation target and making monetary policy. RBI had been focusing on both the consumer price index (CPI) and wholesale price index (WPI) inflation numbers for some time now and feels the CPI component is important because of its direct correlation with the consumer, who is getting affected the most and needs to be protected. India had entered a cycle where high interest rates are leading to lower demand conditions resulting in lower growth and investment. This in turn is aggravating the supply and adding to inflationary pressures thereby inducing the RBI to hold on to higher interest rates DATA : Retail or CPI inflation in December moderated to a three month low of 9.87 percent, while the wholesale or WPI was at 5-month low of 6.16 percent during the month. While the Wholesale Price Inflation (WPI) remains near the comfort zone, the Consumer Price Inflation (CPI) is not. Therefore the decision to increase the interest rate is once again reflection of the shift in terms of the focus from wholesale price inflation to retail inflation.

VIEWS OF RAGHURAM RAJAN : We should be able to reach the 8 percent objective (on consumer price inflation) by the end of the year with this rate hike, which in turn will aid sustainable growth in the long term The 25 bps increase in the repo is needed to set the economy securely on the recommended disinflationary path. The best way to sustain growth over medium-term is to bring down inflation to a tolerable level during the course of the year which will give us more room to take policy action later on that will help growth

"Inflation is also a tax that is grossly inequitable, falling hardest on the very poor. It is only by bringing down inflation to a low and stable level that monetary policy can contribute to reviving consumption and investment in a sustainable way,"

Rajan assured that over a period of time, once inflation cools, the RBI will have more room to cut interest rates and may also advance the rate cuts if the inflation cools faster than expected. BY VISHESH MITTAL