What does RBI really do to the economy with its money policy

Economists at the Reserve Bank of India’s (RBI) monetary policy committee (MPC) have gone into a two-day huddle for the first bimonthly policy review of financial year 2018-19. The policy announcement will be made on April 5.

Dalal Street as well as other financial players will keenly watch the policy outcome, as it would mirror the health of the economy and the money supply situation.

Money policy is a macroeconomic tool laid down by the central bank. It involves management of money supply and interest rates and is demand-side economic policy used by the central bank to manage macroeconomic objectives such as inflation, consumption, growth and liquidity.


Monetary policy is profoundly intertwined with the real economy, as central banks use policy tools to attain macroeconomic objectives in terms of targeting inflation, stable exchange rates and managing growth rates, says Hitesh Jain, AVP – Research, IIFL Investment Managers.
The primary objective of the monetary policy is to set short-term interest rates to control inflation and support growth. In turn, this determines the lending rate of banks and, thus, the cost of capital for companies.

The long-term yield curve moves with monetary policy actions and inflation expectations. “Yields determine returns on bonds. Investors decide their allocation of equities and debt based on returns generated by both the asset classes,” said Rahul Jain, Head, Edelweiss Personal Wealth Advisory.

Monetary policy commentary and interest rate fixing also set the path for inflation expectations. A stable inflationary environment can create macro stability and boost consumption and economic growth, said Jain of Edelweiss.

An accommodative money policy stance influences market sentiment, buoying appreciation in riskier assets in anticipation of higher GDP growth.

Similarly, a hawkish central bank (in case of steep price pressure) can contain liquidity in the banking system and effectively slow down the growth momentum.

Financial markets structurally tend to reflect expectations regarding future economic and monetary policy developments.

Asset classes like equities and bonds factor in future trends in key macro variables, including inflation, output, fiscal situation and current account balance.

“Expanding price-to-earnings multiples conveys expectations of recovery or expansion in growth. Bond yields convey the future pace of inflation, while the yield curve tells you about the economic cycle. Similarly, overheated real estate markets can make a compelling case for a tighter monetary policy,” said Jain of IIFL.

Conversely, deflationary price trends across asset classes often prompt central banks to turn accommodative.

Central banks certainly care about financial stability and accordingly endeavour to decipher the underlying current in various asset classes before formulating the monetary policy.

Monetary policy this time around could largely be a non-event, with most market watchers expecting no change in policy rates.