Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 1 - Structure & Framework of Monetary Policy in India - An Overview

Monetary Policy - Defining Realistic Objectives

Notwithstanding the agreement that financial stability should be an objective of central banks, the role of monetary policy per se in maintaining financial stability remains a matter of debate. Monetary policy is considered to be too blunt an instrument to achieve financial stability, especially to counter threats from asset price misalignments. First, it is argued that it is difficult to adjudge ex ante as to whether asset price misalignments are bubbles or not. Second, even if the central bank can identify a bubble in real time, the typical monetary tightening measures - such as moderate increases in interest rates - might be ineffective in containing or deflating asset price bubbles. In view of these limitations on direct monetary policy actions as also the fact that inflationary pressures take more than the usual time to surface in conditions of low inflation, central banks are advised to take cognisance of emerging financial imbalances by lengthening their monetary policy horizons beyond the usual two-year framework. In addition, central banks can contribute to financial stability through effective regulation and supervision to ensure that banks are well-capitalised and well-diversified.

Encouraging more transparency in accounting and disclosure practices, ensuring integrity of payment and settlement systems and provision of the lender-of-last-resort facility are also needed to maintain financial stability.

Apart from price stability and financial stability, availability of credit for productive purposes remains an important objective of monetary policy, at least in developing and emerging economies. At the same time, in consonance with reforms in many of these economies, there is a shift away from credit controls and directed credit programmes often at concessional prices towards a regime of credit allocation based on the market-oriented price of credit. A key challenge in this regard is to channel credit to the relatively disadvantaged sections of society.

Bank credit is important not only because it finances growth, but also is an important channel of monetary policy transmission mechanism. The 'credit channel' of transmission holds even for central banks that rely on interest rates to convey their policy stance and it also augments the effects of the traditional interest rate channel. For this channel to be effective, however, it is critical that banks price various risks appropriately onto their lending rates. While such risk assessment techniques are in place in advanced economies, these remain underdeveloped in emerging market economies due to the lack of adequate and timely information and large transaction costs. Availability of improved information base will enable banks to make informed choice of their risk profiles and lead to efficient pricing of risk. While leading to an efficient allocation of resources, the credit channel also enhances the efficacy of monetary policy signals. Thus, improvements in the credit delivery mechanism are necessary for monetary policy signals to have the expected effect on output and prices.

Financial innovations have impacted not only upon the objectives of monetary policy but also on the strategies and tactics to conduct monetary policy. With financial innovations imparting a degree of instability to money demand and velocity of money, central banks in many countries have eschewed setting unique intermediate targets or following some fixed rule of monetary policy. There is a growing realisation that given the increasing uncertainties and latent risks in financial markets in recent times, a single model or a limited set of indicators is not a sufficient guide for monetary policy. Instead, an encompassing and integrated set of data is required. Many central banks now follow a 'multiple indicator approach' and monitor a large range of macroeconomic indictors, which carry information about the ultimate objectives. At the same time, as noted above, large movements in monetary and credit aggregates are believed to provide lead information on future financial imbalances. Moreover, in the long-run, inflation is still believed to be a monetary phenomenon. Accordingly, many prominent central banks such as the European Central Bank continue to monitor monetary aggregates even as others have de-emphasised these aggregates.

With shifts away from monetary targeting regime, short-term interest rates have emerged as operative target/instrument of monetary policy in many economies, both developed and developing. Such central banks manage liquidity to steer monetary conditions in consonance with the overall policy objectives of price stability and growth. Central banks usually forecast market liquidity and then conduct open market operations to impact the interest rate structure to affect the real economy. Furthermore, reflecting the market orientation of monetary policy, direct instruments of monetary management have given way to market-based instruments. Even within the set of indirect instruments, instruments such as cash reserve ratios have been de-emphasised and, in many countries, their use is restricted to stabilise money markets. In order to allow the interplay of market forces, most central banks prefer to prescribe reserve requirements on an average basis and encase interest rates in a corridor, rather than target a particular point. Given the market-orientation of monetary policies, central banks have recognised the need to strengthen their balance sheets in order to be able to meet unforeseen contingencies that may arise from their market operations. If balance sheet of a central bank is not strong enough, it could be constrained from taking the necessary market operations. Strong balance sheets, therefore, increase the credibility of the central banks and hence, stabilise market expectations.

For monetary policy to remain effective, its operating procedures and instruments will necessitate continuous refinements. Monetary policy actions affect output and prices with long and variable lags. Despite substantial progress, the precise channels of monetary transmission remain a "black-box". Prices are typically quite sluggish - almost unchanged for one year and it can take almost two years for monetary policy to have a noticeable effect on prices, although some evidence suggests that, in the case of emerging economies, the lags may be somewhat shorter. The effectiveness of monetary policy signals depends upon the speed with which the policy rates are transmitted to market rates of interest. Cross-country evidence suggests that this pass-through to interest rates is only partial in the short-term. Although it increases over time, it is still usually less than complete. Finally, monetary authorities in future will have to contend with implications of electronic money on the transmission process. The dominant view is that monetary policy is likely to remain a key instrument of macroeconomic stabilisation albeit its effectiveness could be weakened to some extent by the growing use of electronic money.

Structural reforms in the Indian economy since early 1990s impacted upon the various aspects of monetary policy - its objectives, strategies and tactics. As regards objectives, price stability and ensuring adequate credit to productive sectors of the economy have been the twin objectives of monetary policy since Independence. The relative emphasis between these two objectives depends on the underlying economic conditions and is spelt out from time to time. Although with the introduction of the structural reforms, there has been a shift in the policy from a planned and administered interest rate system to a market-oriented financial system, credit availability remains an important objective of monetary policy in India. In the pre-1990s period, credit allocation and administered pricing certainly ensured a reasonable level of credit flow in the desired direction at the desired price, but at a cost along with inefficiencies as well as distortions. In such a situation, the cost had to be borne in different ways, including statutory pre-emptions - as high as 63.5 per cent of the incremental deposits of banks in 1992. Policies of liberalisation, deregulation and enabling environment of comfortable liquidity at a reasonable price, however, did not automatically translate into credit flow at reasonable interest rates as banks continued to charge interest rates to various categories of borrowers by their category per se -whether agriculture or small scale industry - rather than based on actual assessment of risks for each borrower. The Reserve Bank's endeavour in the past few years has, therefore, been to reduce transaction and information costs so that credit availability to such sectors is available at reasonable interest rates.

At the same time, with the opening up of the economy since the early 1990s, financial stability has now emerged as a key consideration in the conduct of monetary policy. Monetary management has now to contend with vicissitudes of capital flows and volatility in exchange rates. Due to large capital flows and, in recent years, surpluses in the current account, the overall balance of payments have recorded persistent growing surpluses since 1993-94 (excepting one year, 1995-96). Such large surpluses have been absorbed by the Reserve Bank in its foreign exchange reserves. Whereas the distinction between short term and long term flows is conceptually clear, in practice, however, it is not always easy to distinguish between the two for operational purposes. Moreover, at any given time, some flows could be of an enduring nature whereas others could be temporary and, hence, reversible. More importantly, what appears to be short-term, could tend to last longer and vice versa, imparting a dynamic dimension to judgment about their relative composition (RBI, 2003). In a scenario of uncertainty facing the authorities in determining temporary or permanent nature of inflows, it is prudent to presume that such flows are temporary till such time that they are firmly established to be of a permanent nature.

Large purchases of foreign exchange by the central bank from the market have an expansionary effect on domestic money supply and, therefore, pose challenges for monetary management. Monetary policy had to manage not only these persistent surpluses but also episodes of volatility in the foreign exchange market. Although capital flows have been largely stable, reflecting a cautious approach to capital account liberalisation, there have been nonetheless a few episodes of volatility in capital flows and exchange rates. As maintaining orderly conditions in the foreign exchange market is an important objective of monetary policy, monetary authorities have to face potential conflicts between the interest rate and exchange rate objectives. The bouts of volatility in exchange rate may necessitate that market conditions are rendered less liquid and interest rates are kept high. This policy has implications for promoting domestic growth but the larger objective of evading the likely potential disruption of domestic activities arising out of exchange rate crisis also needs to be kept in view. Given the imperfections in the foreign exchange market, the exchange rate objective may predominate due to emphasis on avoidance of undue volatility.

Financial stability concerns arise also due to the move from a Government-dominated financial system to a market oriented one. In the past, the Government domination was imparting too much stability through rigidity and too little efficiency. In this context, enhancing efficiency while at the same time, avoiding instability in the system, has been the challenge for the regulators in India. Financial stability entails:

1. ensuring uninterrupted financial transactions;

2. maintenance of a level of confidence in the financial system amongst all the participants and stakeholders; and

3. absence of excess volatility that unduly and adversely affects real economic activity.

Such financial stability has to be particularly ensured when the financial system is undergoing structural changes to promote efficiency.

In India, the vulnerability to real sector shocks has the potential to significantly affect financial stability. The major sources of shocks in India are very sharp increases in oil prices and extraordinary monsoon failures with consequent impact on the agricultural sector. Therefore, the weight to financial stability in India is higher than in many other countries.

Financial integration and innovations have also necessitated refinements in the strategies and tactics of monetary policy in India. In order to meet challenges thrown by financial liberalisation and the growing complexities of monetary management, it was felt that monetary policy based exclusively on a money demand function could lack precision. Accordingly, the Reserve Bank switched from a monetary targeting framework to a multiple indicator approach. Short-term interest rates have emerged as signals of monetary policy stance. A significant shift is the move towards market-based instruments away from direct instruments of monetary management. A key step has been the introduction of a liquidity management framework in which market liquidity is now modulated through a mix of open market (including repo) operations and changes in reserve requirements and standing facilities, reinforced by changes in the policy rates. These arrangements have been quite effective in the recent years in managing liquidity in the system, especially in the context of persistent capital flows. The introduction of the Market Stabilisation Scheme has provided further flexibility to the Reserve Bank in its market operations. With the market orientation of monetary policy, the Reserve Bank, like most other central banks, has initiated several measures to strengthen the integrity of its balance sheet.

Over the past few years, the process of monetary policy formulation has become relatively more articulate, consultative and participative with external orientation, while the internal work processes have also been re-engineered to focus on technical analysis, coordination, horizontal management, rapid responses and being market savvy. The stance of monetary policy and the rationale are communicated to the public in a variety of ways, the most important being the monetary policy statements. The communications strategy and provision of timely information at regular intervals have facilitated the conduct of policy in an increasingly market-oriented environment.