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Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]
Module: 2 - Monetary Policy Framework : International Experience
Operating Procedures of Monetary Policy
With short-term interest rates emerging as instruments of monetary policy, central banks need to modulate liquidity in order to stabilise the money markets. In fact, the power of monetary policy stems from the central bank's monopoly over primary money in the economy. The key issue in monetary policy design is to determine the form and pricing of primary liquidity with a view to impacting the overall objectives through the available channels of monetary policy transmission. The operating procedures of monetary policy are, therefore, changing as central banks cope with the opportunities and challenges of financial liberalisation. There are several choices to make in terms of the appropriate regime, the deployment of particular sets of instruments and their impact on the central bank balance sheet and finally, the linkages with the parallel framework of financial stability.
Alongside advanced economies, the operating procedures of monetary policy in EMEs have also undergone changes in the context of an overall shift in the paradigm of the financing framework. Changes in the operating procedure in most EMEs (especially, transition economies), however, had to be calibrated with the development of a market mechanism for resource allocation by the financial system, in terms of building markets, deregulating interest rates and allowing financial intermediaries freedom of portfolio allocation.
The search for an alternate operating procedure of monetary policy is now coalescing into a strategy of liquidity management which broadly follows a two-step procedure of estimating market liquidity, autonomous of policy action, to initiate liquidity operations to steer monetary conditions. A key advantage of this framework is that it is possible to switch between quantitative targets and interest rate targets in response to the macroeconomic circumstances of the economy. In consonance with the growing market orientation of the economy, most central banks try to build in automatic stabilisers in the liquidity management framework itself. First, reserve requirements, set on an average basis, allow the financial system the leverage to adjust to temporary/seasonal liquidity shocks on its own account without central bank action. A second automatic stabiliser results from the central banks' preference for encasing short-term interest rates in a corridor around some optimal rate rather than at a point target rate. For instance, Australia, Canada, Malaysia and New Zealand currently operate a 50 basis point spread corridor while the European Central Bank has a wider 100 basis point band. The precise position of the short-term interest rate in the corridor depends on the liquidity position of the market, especially in case reserve requirements are set on an average basis, and the countervailing liquidity operations of the central bank. A sine qua non of the liquidity management framework, therefore, is the ability of the central bank to define and defend an interest rate corridor around the policy rate. The ceiling (and the floor) of the corridor is set by the prices of the standing lending (and deposit) facilities. At the heart of the efficacy of the liquidity management framework is the ability of the central bank to forecast market liquidity (Box III.2). A number of central banks such as the Bank of England, the European Central Bank and the Bank of Japan publish forecasts of 'autonomous' factors that impact upon bank liquidity to provide the market a guide to monetary policy action. Beyond the design of the liquidity management strategy, the relative efficacy of alternate instruments of monetary policy also poses challenges for monetary management (Box III.3).
Box III.2
Forecasting Market Liquidity
Most central banks are putting in place a strategy of liquidity management in which market liquidity is modulated by open market operations to steer monetary conditions to the desired trajectory. At the core of this exercise is an estimate of liquidity conditions prior to policy action. For this purpose, the bifurcation of the central bank balance sheet into autonomous liquidity and policy position is useful. Autonomous liquidity comprises balance sheet flows arising out of regular central banking functions such as issue of currency, banker to government and banker to banks. If the demand for market liquidity, proxied by the demand for bank reserves, is in excess of autonomous liquidity, the central bank could absorb primary liquidity (through changes in the policy position) to balance the market. Alternately, interest rates change to clear the market for bank reserves through the liquidity effect.
Central banks, therefore, typically begin by estimating the demand for bank reserves. This is usually a function of reserve requirements (which determines required reserves), the volume of transactions (which determines settlement balances) and the opportunity cost of holding bank reserves (which determines excess reserves). This is supplemented by a forecast of autonomous liquidity. This, in turn, depends on a variety of factors such as the fiscal deficit (which determines the Government's recourse to the central bank), the balance of payments position (which determines central bank's foreign assets) and transactions demand (which determines cash demand). These two sets of projections provide an estimate of the ex ante market liquidity conditions.
The estimation of the market liquidity is often difficult in view of its complex dynamics. First, if banks are allowed to maintain their reserve requirements on an average basis, the central bank has to take day-to-day bank portfolio reallocations between bank reserves and the money and government securities markets. Second, the demand for settlement balances often fluctuates with trading volumes rather than administrative requirements. Third, in case of gross settlement systems, there is also the demand for intra-day liquidity depending on the sequence of settlement of debits and credits. Fourth, the estimation of the fiscal gap, especially on a day-to-day basis, is difficult because the presentation of cheques issued could be guided by the liquidity position of a variety of entities, including employees, government contractors and tax payers receiving refunds. Fifth, the estimation of capital flows is also challenging given their intrinsic volatility. Finally, it is difficult to get a fix on the seasonality of cash demand, especially in economies where festivals are not calendar date-specific.
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The ability of a central bank to carry its market operations effectively depends on the strength of its balance sheet. This implies that the central bank must weigh the relative costs of market stabilisation and the implications of the fragility of its own balance sheet in deploying the instruments of monetary control. Accordingly, central bank balance sheets and accounting practices have attracted a great deal of attention in recent years.
To conclude this Section, it is evident that the transformation of monetary policy in the wake of financial sector reforms is far from complete. While price stability has emerged as a key policy objective, the growing integration and globalisation of the economies have thrown new challenges to monetary policy. In the context of sharp swings in capital flows and exchange rates, ensuring orderly conditions in the financial markets has emerged as a key policy concern. More generally, monetary policy is expected to maintain financial stability although the instruments for this purpose and their efficacy remain a matter of debate. On the issue of achieving price stability on a sustainable basis and to stabilise inflation expectations, there is a reasonably clear consensus about the need to ensure central bank autonomy from the budgetary requirements of the fisc. This is necessary in order to accord monetary management the necessary flexibility to attain its objectives.
Box III.3
Instruments of Monetary Policy
During the 1990s, there has been an increasing shift from direct to indirect instruments of monetary policy. This is in consonance with the consistent preference for market-based instruments of monetary policy. The process has been reinforced by a switch, within the group of indirect instruments, from relatively less market-oriented instruments such as reserve requirements to relatively more market-oriented instruments such as open market operations.
The cash reserve ratio (CRR) remains a powerful instrument of monetary policy in developing economies. It not only impounds liquidity at the first instance but also directly impacts banks' cost of raising funds since a portion of deposit mobilisation is continuously impounded by the central bank. Reserve requirements are especially effective in developing countries as their financial markets are not mature enough for open market operations. The principal drawback of reserve requirements is that they impose an indirect tax on the banking system as an across-the-board levy, which does not take into consideration the relative liquidity position of the players in the credit markets.
Most central banks have, therefore, gradually de-emphasised the use of reserve requirements, and as noted earlier, prefer open market operations as a tool of monetary policy. This allows them to adjust market liquidity and impact on the interest rate structure at varying tenors through an auction mechanism in which market players are able to bid their preferences. For such market operations to be effective, the secondary markets need to be deep and liquid. At the same time, the central bank must have a sufficient stock of eligible securities to undertake market operations.
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Box III.4
Central Bank Balance Sheets
It is sometimes argued that central banks may not require reserves at all, since the owner in cases, is the government itself. Notwithstanding this initial thinking regarding the uniqueness of central banking, most central banks now usually follow conservative accounting norms of income recognition such as periodic revaluation of assets and ignoring unrealised gains. A number of central banks are now adopting the International Accounting Standards (IAS), while the European Central Bank (ECB) System of Central Banks prefer the ECB Generally Accepted Accounting Principles (ECB GAAP). The International Monetary Fund has introduced a comprehensive safeguard assessments standard, ELRIC, based on five areas: External audit mechanism, Legal structure and independence, financial Reporting (based on the IAS), Internal audit mechanism and system of internal Controls. It is, however, recognised that the net worth of a central bank is difficult to establish, especially as the 'franchise' value of currency issuance is almost impossible to measure. While explicit contingent liabilities could be valued, the lender-of-last-resort function is difficult to provide for.
With the increasing market orientation of monetary policy, there is now an emerging consensus that well-capitalised central banks are relatively more credible because they can bear larger quasi-fiscal costs of market stabilisation. Most central banks, therefore, prefer to maintain sufficient reserves to ensure that monetary policy is not limited by balance sheet considerations. In particular, central banks in EMEs tend to maintain larger reserves, especially as the fiscal position is often not strong enough to protect central bank balance sheets.
Central bank legislations often link the size of reserves to the size of the balance sheet, paid-up capital, annual surplus, or some macroeconomic variable, such as GDP or money supply. A related issue is to determine the share of the central bank (i.e., in the form of reserves), the Government and non-Government owners in central bank income. In most cases, central banks have the first charge on annual income. Although governments typically appropriate the dominant share (often up to 90 per cent), especially given the right of seignorage for having farmed out the right of issue, this is counterbalanced by parallel restrictions on the monetisation of the fiscal deficit.
In brief, the health of the central bank balance sheet is increasingly viewed as an essential element in the credibility of monetary policy. Most central banks are now strengthening their balance sheets by building adequate reserves to ensure that balance sheet considerations do not hamper their ability to undertake policy actions.
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In view of the growing complexities of monetary management, most central banks now track multiple indicators although the evidence suggests that a clear commitment - be it an inflation forecast or a traditional intermediate target - is useful in anchoring the path of inflation expectations. The operating procedures of monetary policy have acquired a greater market orientation than ever before. In view of the need to ensure central bank credibility, there is an increasing focus on strengthening the central banks' balance sheet.
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