G-20 Draft Highlights Inflation, Growth Risks

The Group of 20 nations will say oil and food prices threaten to spur global inflation even as higher credit costs damp the outlook for economic growth, according to an official from a G-20 country.

Rising energy and food prices will remain an important source of price pressures, a draft of the G-20 communiqué says, according to the official, who asked not to be identified. The G- 20 will release its statement around 1:30 p.m. in Kleinmond, near Cape Town, today. While the official said currencies were not mentioned in the draft, Canada's central bank governor David Dodge told reporters yesterday there was a frank sharing of views on the matter.

Central bankers around the world are trying to curb inflation just as fallout from the biggest U.S. housing slump in 16 years spreads through financial markets and a weaker dollar threatens to hurt growth. While the U.S. Federal Reserve has cut interest rates twice since September to shore up U.S. expansion, policy makers in India, China and the 13 euro nations say they are worried about accelerating inflation.

The price of oil has surged 58 percent in the past year and wheat prices have increased 60 percent in the same period. European inflation accelerated to the fastest pace in two years last month and Chinese inflation matched the quickest pace in a decade.

Monetary authorities in the G-20 will need to assess the effects on the inflation outlook, the official quoted the draft statement as saying.

U.S. Treasury Secretary Henry Paulson, European Central Bank President Jean-Claude Trichet and Chinese central bank Governor Zhou Xiaochuan are among the G-20 finance ministers and central bankers meeting this weekend in South Africa.

The credit collapse that began in August is likely to force banks, brokerages and hedge funds to cut lending by $2 trillion, risking a substantial recession in the U.S., Goldman Sachs Group Inc. economist Jan Hatzius wrote in a report dated Nov. 15.

Dodge told reporters yesterday that the impact of market turbulence is likely to be more prolonged than forecast at last month's meeting of the G-7 nations.

Downside risks to the near-term outlook have increased as a consequence of recent financial-market disturbances, the G-20 draft says, according to the official. While the likely slowdown in global economic outlook is expected to be modest, its extent and duration remain to be seen, the statement says.

Slower Growth

Slower U.S. growth has dulled the allure of dollar investments, prompting some investors to shift capital into other currencies. With China still controlling the yuan's exchange rate more than two years after abandoning a peg to the dollar, money has flooded into Europe and Canada.

The U.S. currency has dropped about 11 percent so far this year, based on the Federal Reserve's U.S. Trade-Weighted Major Currency Index. It fell this month to its weakest against the euro since the European currency's debut in 1999, the lowest against Canada's dollar since it was floated in 1950 and to a 26- year low versus the pound.

There was a genuine concern on the part of a lot of countries on the turbulence in the currency markets, Dodge told reporters yesterday. Bank of England Governor Mervyn King said Nov. 14 he's concerned that China's foreign exchange policies are stoking great currency tensions.

OPEC countries meeting this weekend in Riyadh, Saudi Arabia, have been debating the dollar's decline, which is making it harder for them to manage inflation and keep their pegs to the currency at the same time. Gulf states including Saudi Arabia and the United Arab Emirates may revalue their currencies in as soon as in a month's time, a person familiar with Saudi monetary policy said yesterday.

The G-20 comprises Argentina, Japan, Australia, Korea, Brazil, Mexico, Canada, Russia, China, Saudi Arabia, France, South Africa, Germany, Turkey, India, United Kingdom, Indonesia, United States, Italy, European Union.

Source - Bloomberg

What is Monetary Policy? - India Story

Monetary Policy as it states is all about Money. Money plays an important role in the economic system we see the use of money at every step of life indeed it would be hard to imagine life without money! The main function of money in an economic system is to facilitate the exchange of goods and services.

The actions of a central bank, currency board or other regulatory committee, that determine the size and rate of growth of the money supply, which in turn affects interest rates.

In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy.

In India context central bank is referred to as RBI (Reserve bank of India)

A central bank can be said to have two main kinds of functions:
(1) macroeconomic when regulating inflation and price stability and
(2) microeconomic when functioning as a lender of last resort.

Macroeconomic Influences

As it is responsible for price stability, the central bank must regulate the level of inflation by controlling money supplies by means of monetary policy. The central bank performs open market transactions that either inject the market with liquidity or absorb extra funds, directly affecting the level of inflation. To increase the amount of money in circulation and decrease the interest rate (cost) for borrowing, the central bank can buy government bonds, bills, or other government-issued notes. This buying can, however, also lead to higher inflation. When it needs to absorb money to reduce inflation, the central bank will sell government bonds on the open market, which increases the interest rate and discourages borrowing. Open market operations are the key means by which a central bank controls inflation, money supply, and price stability.

Microeconomic Influences

The establishment of central banks as lender of last resort has pushed the need for their freedom from commercial banking. A commercial bank offers funds to clients on a first come, first serve basis. If the commercial bank does not have enough liquidity to meet its clients' demands (commercial banks typically do not hold reserves equal to the needs of the entire market), the commercial bank can turn to the central bank to borrow additional funds. This provides the system with stability in an objective way; central banks cannot favor any particular commercial bank. As such, many central banks will hold commercial-bank reserves that are based on a ratio of each commercial bank's deposits. Thus, a central bank may require all commercial banks to keep, for example, a 1:10 reserve/deposit ratio. Enforcing a policy of commercial bank reserves functions as another means to control money supply in the market.

The rate at which commercial banks and other lending facilities can borrow short-term funds from the central bank is called the discount rate (which is set by the central bank and provides a base rate for interest rates). It has been argued that, for open market transactions to become more efficient, the discount rate should keep the banks from perpetual borrowing, which would disrupt the market's money supply and the central bank's monetary policy. By borrowing too much, the commercial bank will be circulating more money in the system. Use of the discount rate can be restricted by making it unattractive when used repeatedly.


What are elements of Monetary Policy?

As said earlier, The Central Bank controls the money supply and credit in the best interests of the economy. The bank does this by taking recourse to various instruments.

1) Bank Rate Policy
The bank rate is the rate at which the central bank lends funds to banks, against approved securities or eligible bills of exchange. The effect of a change in the bank rate is to change the cost of securing funds from the central bank. An increase in the bank rate increases the costs of securing funds and of borrowing reserves from the central bank. This will reduce the ability of banks to create credit and thus to increase the money supply. A rise in the bank rate will then cause the banks to increase the rates at which they lend. This will then discourage businessmen and others from taking loans, thus reducing the volume of credit. A decrease in the bank rate will have the opposite effect.

2) Open Market Operations
OMO is the buying and selling of government securities by the Central Bank from/to the public and banks on its own account. It does not matter whether the securities are bought from or sold to the public or banks because ultimately the amounts will be deposited in or transferred from some bank. The sale of government securities to banks will have the effect of reducing their reserves. This directly reduces the bank’s ability to give credit and therefore decrease the money supply in the economy. When the Central Bank buys securities from the banks it gives the banks a cheque drawn on itself in payment for the securities. When the cheque clears, the Central Bank increases the reserves of the bankby the particular amount. This directly increases the bank’s ability to give credit and thus increase the money supply.

3) Varying Reserve Requirements
Banks are obliged to maintain reserves with the Central Bank on two accounts. One is the Cash Reserve Ratio (CRR) and the other is the Statutory Liquidity Ratio (SLR). Under CRR the banks are required to deposit with the Central Bank a percentage of their net demand and time liabilities. Varying the CRR is a tool of monetary and credit control. An increase in the CRR has the effect of reducing the banks excess reserves and thus curtails their ability to give credit. Reducing the CRR has the effect of increasing the bank’s excess reserves, which increases its power to give credit.
The SLR requires the banks to maintain a specified percentage of their net total demand and time liabilities in the form of designated liquid assets which may be (a) excess reserves (b) unencumbered (are not acting as security for loans from the Central Bank) government and other approved securities (securities whose repayment is guaranteed by the government) and (c) current account balances with other banks. Varying the SLR affects the freedom of banks to sell government securities or borrow against them from the Central Bank. This affects their freedom to increase the quantum of credit and therefore the money supply. Increasing the SLR reduces the ability of banks to give credit and vice versa.