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

Module: 2 Monetary Policy Framework In India
Preface

It is now widely agreed that monetary policy can contribute to sustainable economic growth by maintaining low and stable inflation. Within this overall objective of price stability, central banks attempt to stabilise output around its potential. In order to create enabling conditions for low and stable inflation as well as inflation expectations, there is an emerging consensus to secure the independence of monetary policy from the budgetary requirements of the fisc. A number of countries now limit Government access to central bank financing, reinforced by fiscal responsibility legislation.

With the growing globalisation and integration of economies, monetary authorities are now required to pay greater attention to external developments. Swings in trade flows and, especially capital flows are quite common and these impart a high degree of volatility to exchange rates. Even in an environment of price stability, the 1990s witnessed episodes of financial instability. The presumption that price stability ensures financial stability is thus not true, at least in the short-run. Ensuring orderly conditions in financial markets and maintenance of systemic financial stability has thus emerged as an important objective of monetary policy, even for central banks not involved with banking regulation and supervision.

Financial innovations have also impacted upon the conduct of monetary policy. In consonance with the preference for a degree of operational flexibility in a complex macroeconomic environment, most central banks are beginning to eschew setting unique intermediate targets or following some fixed rule of monetary policy. They, instead, prefer to monitor a range of macroeconomic indictors, which carry information about the ultimate objectives. Short-term interest rates have emerged as operative target/ instruments of monetary policy. Most central banks now prefer to 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. Along with these developments, central banks have strengthened their balance sheets in order to be able to meet unforeseen contingencies that may arise from their market operations.

In India, the opening up of the economy in the early 1990s had a significant impact upon the conduct of monetary policy. Price stability remains the key objective of monetary policy and there is virtually a national consensus that high inflation is not good. Inflation expectations and inflation tolerance have come down. Adherence to the Fiscal Responsibility and Budget Management Act should stabilise inflation expectations and hence contribute to the objective of price stability. While adequate availability of credit to meet investment demand continues to remain an important objective, the growing integration of the Indian economy with the global economy has led to financial stability emerging as a key consideration in the conduct of monetary policy. Although there are complementarities between the objectives in the long run, there are certain trade-offs in the short run.

In order to meet challenges thrown by financial liberalisation and the growing complexities of monetary management, the Reserve Bank switched from a monetary targeting framework to a multiple indicator approach. Short-term interest rates have emerged as indicators of the monetary policy stance. A significant shift is the move towards market-based instruments away from direct instruments of monetary management. In line with international trends, the Reserve Bank has now put in place 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, including the LAF rates and the Bank Rate. 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.

As monetary policy emerges as the primary instrument of macroeconomic stabilisation, the Reserve Bank, like most other central banks, has initiated several measures to strengthen the health 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. 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 information have facilitated conduct of monetary policy in an increasingly market-oriented environment.

To conclude, while financial and external liberalisation present opportunities, they also throw challenges for policy authorities. Monetary authorities are increasingly required to take cognisance of not only domestic shocks but also external shocks. Given their objectives, central banks are required to monitor various segments of financial markets to ensure orderly conditions. Given the random nature of the shocks hitting the economy, central banks are increasingly acting as shock absorbers. In order to manage these shocks effectively, a steady stream of innovations is required by central banks in terms of instruments and operating procedures while strengthening their balance sheets.