Project on assessment of key issues related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Epilogue - Impact of Structural Reforms on the Conduct of Monetary Policy

To conclude, structural reforms initiated in the Indian economy in the early 1990s had a significant impact on the conduct of monetary policy in terms of its objectives, strategies and tactics. Financial as well as external liberalisation has increased integration of the Indian economy with the rest of the world. This has benefits for the economy but also throws challenges for policy authorities. External demand conditions, sharp swings in capital flows and volatile exchange rates have to be factored in the process of monetary policy formulation. As it is, monetary policy operates in an uncertain environment. These uncertainties are exacerbated in an environment of greater trade and financial integration, warranting close monitoring.

1. First, apart from price stability and credit availability, financial stability has gradually emerged as a key consideration in the conduct of monetary policy.

2. Second, the instruments and operating procedures of monetary policy had to be constantly refined to meet the challenges thrown up by the vicissitudes of capital flows and a market-determined exchange rate.

In order to meet their price and financial stability objectives, central banks are constantly required to operate in various segments of financial markets to ensure orderly conditions. While in the long-run these objectives reinforce each other, monetary policy is faced with various trade-offs in the short-run. Given the random nature of the shocks impacting the economy, central banks are increasingly acting as shock absorbers. In order to manage these shocks effectively, a constant innovation is required by central banks in terms of instruments and operating procedures while strengthening their balance sheets. Illustratively, in India, existing arrangements to modulate liquidity had to be supplemented with innovations such as Market Stabilisation Scheme.

Unlike in the case of trade integration where benefits to all countries are demonstrable, in case of financial integration, a "threshold" is important for a country to get full benefits. A judgmental view needs to be taken whether and when a country has reached the "threshold" and the financial integration should be approached cautiously with a plausible road map by answering questions in a country-specific context and institutional features. India has been adhering to a cautious and calibrated approach in reforms so far and there is merit in adopting a 'road map approach' building on the strengths that have already been developed.

An assessment of monetary management since early 1990s shows that monetary policy has been reasonably successful in meeting its key objectives.

1. Price stability through low and stable inflation has been maintained since the second half of the 1990s. More importantly, this regime of low and stable inflation has, in turn, stabilised inflation expectations and inflation tolerance in the economy has come down. It is, therefore, critical that inflation expectations are kept low.

2. Second, flow of credit to productive sectors has been maintained in the last 3-4 years. Recent efforts to reduce information and transaction costs as well as to impart greater flexibility to the interest rate structure of the banks are expected to further improve availability of credit to the various sectors.

3. Third, financial stability has been ensured in contrast to the experience of many developing and emerging economies.

While assessing the conduct of monetary policy in recent years, one needs to take cognisance of the fact that the Indian economy witnessed a large number of shocks, both global and domestic. These shocks included a series of financial crises in Asia, Brazil and Russia besides September 11 terrorist attacks in the US, border tensions, sanctions imposed in the aftermath of nuclear tests, political uncertainties and changes in the Government. Monetary policy in India had to be fine tuned to manage all these shocks. Viewed in this light, the success in maintaining price and financial stability is all the more credible.

It needs to be noted that financial stability is also subject to interest rate cycles. Accordingly, the Reserve Bank has been sensitising the market participants for these turns in cycles and they have also been advised to hedge their exposures. Market participants are also being encouraged to gradually gain means of coping with market-orientation. Market infrastructure, technology and institutions have been promoted and strengthened. These measures have added to the effectiveness of monetary policy.

In the context of price stability objective, an issue of debate is as to whether it should be the sole overriding objective of monetary policy in India. A number of factors such as intermittent supply shocks, absence of fully integrated financial markets and dominance of fiscal policy constrain the adoption of price stability as the sole objective. To overcome issues posed by supply shocks, core measures of inflation are often recommended as a target of inflation. In developing countries, a measure of core inflation excluding food items - which can account for more than half of the weight in the index - may not be very meaningful, although from the viewpoint of formulation of monetary policy, it is the underlying inflation or core inflation that is important. While there is a growing consensus on the acceptable rate of inflation, this needs to be better articulated, formalised, and perhaps converted in due course into a mandate from the Government to the Reserve Bank and, in the process to all economic agents. An explicit numerical target is good for anchoring inflation but it comes at a cost. If the explicit inflation target cannot be achieved it weakens the credibility of the central bank. Thus it may not be appropriate to formulate monetary policy based on a simplistic inflation target or a single point inflexible point target as argued by many. Rules can only be viewed as thoughtful adjuncts of policy but cannot be a substitute for risk paradigms. Ultimately, a central bank has to judge the outcome of the policy choices it makes and also take account of and anticipate market expectations, which have become increasingly important for the attainment of desirable outcomes.

As the international experience indicates, a prudent fiscal policy remains the single largest prerequisite for monetary stability. Reforms in the monetary-fiscal interface during the 1990s have been a key factor that imparted greater flexibility to monetary policy. These reforms have taken a significant step forward with the enactment of the Fiscal Responsibility and Budget Management Act, 2003. Strict adherence to these fiscal rules in letter and spirit will help to stabilise inflation expectations and, in turn, keep inflation low and stable in the country while gradually providing increasing flexibility to the Reserve Bank.

Fiscal discipline creates enabling conditions for monetary and financial stability. Monetary policy will have, however, still to grapple with uncertainty in the environment it operates. Incoming economic data - crucial for the conduct of monetary policy - provide, at best, incomplete coverage of economic activity; are subject to substantial sampling errors; become available with only a lag; and, are subject to substantial revisions. Despite substantial empirical research, there is still no unanimity on the channels through which monetary policy affects output and prices. Lags with which monetary policy works remain uncertain and can vary from one business cycle to another. Therefore, policymakers are unable to predict with great confidence how - and how quickly - their own actions are likely to affect the economy. Divergent movements in alternative indicators of inflation in the short-run -for instance, between wholesale and consumer prices in India, as at the present juncture - pose further challenges for the monetary authority in gauging underlying inflationary conditions in the economy. In addition to these uncertainties, short-term risks to monetary management emerge from global macroeconomic imbalances and the associated possibility of disruptive currency adjustments. In the medium to long-term, evolving demographic patterns and the electronic money revolution will add to uncertainties of the transmission mechanism. In the context of these uncertainties, a risk-management approach involving a judgement about the probabilities, costs and benefits of the various possible outcomes has been recommended for the conduct of monetary policy.

Uncertainty about how economies operate and about monetary policy itself is, however, no excuse for not pursuing price stability. While year-to-year inflation may vary depending upon the intensity of supply shocks, monetary policy can stabilise inflation expectations at low levels. An environment of sustained low and stable inflation is conducive for financial savings, with beneficial impact on investment in the economy and for sustained growth and employment. Price stability is all the more important for an economy like India, with a large proportion of poor population that has no hedges against inflation.