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

Introduction

In India, the transition of economic policies in general, and financial sector policies in particular, from a control oriented regime to a liberalised but regulated regime has been reflected in changes in the nature of monetary management. While the basic objectives of monetary policy, namely price stability and ensuring credit flow to support growth, have remained unchanged, the underlying operating environment for monetary policy has undergone a significant transformation. An increasing concern is the maintenance of financial stability. The basic emphasis of monetary policy since the initiation of reforms has been to reduce segmentation through better linkages between various segments of the financial markets including money, Government securities and forex markets. The key development that has enabled a more independent monetary policy environment was the discontinuation of automatic monetisation of the Government's fiscal deficit through an agreement between the Government and the Reserve Bank in 1997. The enactment of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 has strengthened this further. Development of the monetary policy framework has also involved a great deal of institutional initiatives to enable efficient functioning of the money market: development of appropriate trading, payments and settlement systems along with technological infrastructure.

Against this brief overview, this Section focuses on the key changes in the monetary policy framework that became necessary in the liberalised economic regime. As in Section I, the discussion is organised under three broad heads: objectives, intermediate targets and operating procedures.

The preamble of the Reserve Bank of India Act, 1934 enjoins the central bank "to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage". Within this broad mandate, the Reserve Bank's monetary policy pursues the twin objectives of price stability and ensuring the availability of credit to the productive sectors in the Indian economy. The emphasis between the twin objectives of price stability and growth has, however, varied over time depending on the evolving price-output situation. Initially, this was guided by the concept of developmental central banking crystallised in the First Five Year Plan, which required the Reserve Bank to create an institutional framework for industrial as well as rural credit to support economic growth (GoI,1951)¹. This reflected a widespread consensus that public investment could spur rapid growth. The concomitant deficit financing associated with public investment began to spill over into inflation and concerns began to be expressed over the inflationary consequences of the fiscal deficit during the 1960s (Iengar, 1959; Rama Rau, 1960; Narasimham, 1968). These concerns gathered momentum during the 1970s as inflation trended up to around nine per cent during the 1970s. Against this backdrop of persistent high inflation, the Chakravarty Committee recommended that price stability emerge as the "dominant" objective of monetary policy with a concomitant commitment to fiscal discipline (RBI, 1985)². Besides the conventional wisdom that fluctuations in prices affected business decisions, inflation was also seen as a social injustice, especially as the poor seldom had hedges against inflation (Rangarajan, 1988).

The case for price stability as the dominant -if not sole - objective of monetary policy gathered momentum in the early years of financial liberalisation. Although it had to stabilise the economy in the face of the balance of payments crisis of 1991, the Reserve Bank emphasised that its ultimate mission was to steer monetary policy with its sights set firmly on inflation control (RBI, 1992). Price stability was seen to be critical to sustain the process of reforms (RBI, 1993). This acquired a new urgency as strong capital flows, after the liberalisation of the external sector, began to push inflation into the double digits. The very fact that inflation could be reined in during the second half of the 1990s by tightening monetary conditions -in turn, enabled by improved monetary-fiscal interface, as discussed later - appeared to demonstrate the potency of monetary policy in ensuring price stability (RBI, 1997). In the latter half of the 1990s, as the economy slowed down, monetary policy pursued an accommodative stance with an explicit policy preference for a softer interest rate regime while continuing a constant vigil on the inflation front. The macroeconomic scenario began to change by the first half of 2004-05. In the face of sharp increases in international commodity prices and the persistence of a large liquidity overhang, the Reserve Bank reaffirmed that maintaining confidence in price stability was a continuing policy objective (RBI, 2004b). The inflation situation would be watched closely in order to respond in a timely and measured manner.

Thus, price stability has been an abiding objective of monetary policy since the early 1950s although the success with price stability has varied over time in response to the evolving monetary-fiscal interface. It is only since the second half of 1990s that both inflation and inflation expectations have moderated substantially (see Module: 3). There is very little disagreement about the fact that price stability should continue to be a key objective of monetary policy. The Advisory Group on Monetary and Financial Policies (Chairman: Shri M. Narasimham) recommended that the Reserve Bank should be mandated a sole price stability objective (RBI, 2000a). There are, however, several constraints in pursuing a sole price stability objective (RBI, 2000).

• The recurrence of supply shocks limits the role of monetary policy in the inflation outcome. Structural factors and supply shocks from within and abroad make inflation in India depend on monetary as well as non-monetary factors

• The persistence of fiscal dominance implies that the debt management function gets inextricably linked with the monetary management function while steering liquidity conditions.

• The absence of fully integrated financial markets suggests that the interest rate transmission channel of policy is rather weak and yet to evolve fully. In particular, the lags in the pass-through from the policy rate to bank lending rates constrain the adoption of inflation targeting.

• The high frequency data requirements including those of a fully dependable inflation rate for targeting purposes are yet to be met.

With the opening up of the Indian economy and its growing integration, monetary policy had to contend not only with price stability but also to ensure orderly conditions in the financial markets (Box III.5). The growing integration of financial markets, while necessary for economic efficiency, posed challenges for monetary management in terms of heightened risks of contagion. Episodes of financial volatility, often sparked off by sudden switches in capital flows in response to various shocks - such as the East Asian financial crisis, sanctions after the nuclear explosions, downgrading of credit ratings, the meltdown of the information technology bubble and the September 11 US terrorist attacks - required a swift monetary policy response. The Reserve Bank, therefore, began to emphasise the need to ensure orderly conditions in financial markets as a prime concern of monetary management. Financial stability is now being recognised as a key consideration in the conduct of monetary policy, in terms of ensuring uninterrupted financial transactions; maintenance of a level of confidence in the financial system amongst all the participants and stakeholders; and absence of excess volatility that unduly and adversely affects real economic activity.

¹The First Five-Year Plan (1951) stated that: "...central banking in a planned economy can hardly be confined to the regulation of the overall supply of credit or to a somewhat negative regulation of the flow of bank credit. It would have to take on a direct and active role, firstly in creating or helping to create the machinery needed for financing developmental activities all over the country and secondly, ensuring that the finance available flows in the directions intended...".

²The Chakavarty Committee set out the following other tasks for the monetary system so that its functioning would be in consonance with the national development strategy as envisaged in the successive Five Year Plans:

1. mobilising the savings of the community and enlarging the financial savings pool;

2. promoting efficiency in the allocation of the savings of the community to relatively productive purposes in accordance with national economic goals;

3. enabling the resource needs of the major 'entrepreneur' in the country, viz., the government, to be met in adequate measure; and,

4. promoting an efficient payments system.