The Sinews of Monetary Policy

While recognising that monetary policy has to be consistent with the overall macroeconomic framework, most economists in the government and the academic world have negative thoughts regarding its role. The miscued appreciation of monetary policy holds sway in India and economists abhor monetary tightening as they have a proclivity towards low interest rates.

Dr C Rangarajan, in his lecture on foundation day of the Indira Gandhi Institute of Development Research (Mumbai) last month, set out a comprehensive analysis, which can become a locus classicus on the subject. Dr Rangarajan emphasised that there should be clearly articulated and publicly set out objectives of monetary policy. Since there are multiple objectives, this raises the issue of assigning to each segment the most appropriate objective. Dr Rangarajan argued that the ‘assignment rule’ favours monetary policy as the most appropriate to achieve the objective of price stability.

In the Indian context, the government is not inclined to set a single objective for monetary policy. The Reserve Bank of India Advisory Group on Transparency of Monetary Policy and Other Financial Policies (2000), chaired by M Narasimham, stressed that if there are multiple objectives, there should be a clear prioritisation with a hierarchy of objectives. Monetary policy has to work on “inflationary expectations”. As Dr Rangarajan succinctly puts it, a crucial issue is whether the target for stabilisation should be the “inflation rate” or the “price level”. In inflation targeting, bygones are bygones, while targeting a price level is a harder policy option. Talk about introducing an element of flexibility in inflation targeting has led to derailing the focus on inflation control.

In the recent period, there has been an unprecedented increase in the rate of inflation, way beyond the acceptable rate. Yet, there is an absence of an unequivocal, strong and unswerving monetary policy.

As part of transparency, there has to be a clear division of responsibilities between the government and the RBI. Ideally, the objectives should be laid out by the government in an agreement with the RBI and then the RBI can be given instrument independence. In the recent period, the government is loath to undertake such a formal agreement and the RBI has also not articulated the need for a clear demarcation of responsibilities. In the absence of such a transparent accord, accountability of both the RBI and the government is opaque and this does not augur well for the effective functioning of monetary policy.

Sequencing of Monetary Policy Measures

It is often argued that the transmission mechanism for monetary policy is weak. This is, essentially, because of the absence of optimal sequencing and timing of measures. For instance, on many occasions, tightening of reserve requirements and increases in policy interest rates are undertaken simultaneously and, therefore, the interest rate transmission mechanism is weak. If liquidity tightening is prior to interest rates’ tightening, the interest rate policy signals are more effective.

There should be a better appreciation of the role of monetary policy in tackling inflation. This will require an accord between the government and the RBI, which should be put in the public domain.

Inflation has been raging at unusually high rates, whatever the basis for calculating inflation–wholesale price index, consumer price index or food inflation. The present policy interest rates, as well as deposit rates, are clearly negative. Moreover, once lending rates move over to the new base rate, lending rates are also expected to be negative. In the absence of early monetary tightening, overheating of the economy can become a major problem in the next 12-18 months and the economy can plunge into a serious crisis, which will then necessitate large and jerky policy action that will be disruptive.

Today’s received doctrine is that markets should not be rocked by harsh measures. While this is unexceptionable, there is a need to keep options open for changes, at any point of time, as often the window of opportunity for monetary policy is limited. More recently, the RBI management had ruled out any increase in interest rates during the inter-review period, unless there were completely unanticipated events. On March 19, however, the RBI announced a token 0.25 percentage point increase in policy interest rates. As Dr Rangarajan said, ‘extraordinary circumstances will warrant extraordinary responses’.

There is merit in liquidity curtailing measures before changes in policy interest rates. The cash reserve ratio (CRR) can be raised by one percentage point from 5.75 per cent to 6.75 per cent in two phases. This will reduce liquidity by Rs 480 billion. Given the large amounts being placed at the reverse repo window and the collaterised borrowing lending obligations (CBLO), it is unlikely that there will be any disruption. There will also be a need to increase the repo rate by 0.50 per cent to 5.50 per cent.

A further increase in CRR by one percentage point by the end of September appears necessary. Large CRR increases in the second half of 2010-11 are best avoided, unless there is an avalanche of capital inflows. If the RBI has concern about the repeated tensions of raising the CRR, the reserve requirements can be put on an auto-pilot by introducing an incremental cash reserve ratio.

As liquidity is tightened, there will inevitably be a pressure on deposit and lending rates, as also government securities yields. This will be desirable as it will work as an anti-inflationary measure. There is a popular misapprehension that higher interest rates are inflationary; quite the contrary, higher interest rates work towards dampening inflation. Delaying monetary policy measures will, at some future point of time, require sledgehammer measures, which can be disruptive. Given the current high inflation rate, the RBI needs to be careful not to give any signal of a soft monetary policy.

All deposit rates, other than the savings bank interest rate, were deregulated in the 1990s. The ostensible reason for continuing RBI control on the savings bank interest rate was to use it as a policy signalling rate. The RBI has frozen the savings bank deposit rate at 3.5 per cent for close to a decade. These accounts relate to a large number of small depositors, including the ‘no frills’ accounts. In an address at the World Consumer Rights Day meeting on March 15, 2007, K J Udeshi, the then chairperson of the Banking Codes and Standards Board of India (BCSBI), said that as banks pay interest on only the minimum balance between the 10th and the end of the month, the effective rate is only 2.8 per cent. Her suggestion was that banks can easily work out the average daily balance and the savings bank deposit holder should be compensated fairly. In April 2009, the RBI came out with a notification that banks will have to pay interest on the daily average balances from April 1, 2010.

It is often argued that the transmission mechanism for monetary policy is weak. This is, essentially, because of the absence of optimal sequencing and timing of measures.

There is a strong case for deregulating the interest rate on savings bank deposit accounts. With a view to tilting the playing field in favour of small depositors, the RBI can move over from the present fixed rate system to a partially liberalised system, and the rate should be a minimum of 3.5 per cent. A bank with a paucity of savings bank accounts will offer a slightly higher rate while banks with an adequate composition of these accounts may not do so. Depositor loyalty is unswerving and depositors do not swirl from one bank to another bank for small marginal gains. If the RBI wishes to continue with its rigid policy of not altering the savings bank rate, it needs to be reminded of US General, George C. Patton, of World War II fame, who said: ‘Lead, follow or get out of the way’.

Coordination of Monetary Policy and Regulation

An IMF Staff Position Note, (Oliver Blanchard et al, Rethinking Macroeconomic Policy SPN/10/03 dated February 12, 2010) discusses the issue of coordination of monetary policy and regulation, and whether regulation and monetary policy should be separated or kept within the same institution. There are problems of coordination when the two segments are lodged in separate institutions and the trend towards separation may need to be reversed. While giving the central bank responsibility for regulation could dilute monetary policy objectives, the authors conclude that separate authorities could be a worse situation. There is much merit in regulation and supervision being in the central bank, which is the ultimate provider of liquidity.

Given the nascent stage of regulatory/ supervisory activities of stock markets, insurance and pension authorities, the important issue in India is to build regulatory/supervisory skills in each segment, and hence the crucial issue is not who regulates/supervises a segment of the financial sector but how the activity is undertaken. There should be an endeavour to develop an interdisciplinary supervisory strategic strike force, which can be effectively deployed.

Development of Macro-Prudential Tools

Lord Adair Turner, (C D Deshmukh Memorial Lecture: After the Crisis, Assessing the Costs and Benefits of Financial Liberalisation, February 15, 2010) says that new tools being considered in the aftermath of the global financial crisis are those which were rejected in the industrial countries 30-40 years ago. These include discretionary variation of capital requirements over the cycle, either across the board or in relation to specific sectors and regulations to directly influence borrower/lender behaviour. Lord Turner acknowledges that India has been already using these tools effectively. As such, fashions have a proclivity to come full circle.

Today’s received doctrine is that markets should not be rocked by harsh measures. While this is unexceptionable, there is a need to keep options open for changes, at any point of time, as often the window of opportunity for monetary policy is limited.

A theme underlying the Indian approach to bank/financial institution failures is that in a democracy, we cannot let any bank fail. Since the Palai Central Bank failure in 1960, no bank has been allowed to fail. Invariably, the failing bank has been merged with larger banks and the cost has invariably been borne by the exchequer. The experience in emerging markets has been that the cost of bailouts can be as high as 20-30 per cent of the GDP. In the Indian case, such bailouts just cannot be absorbed by the fisc. Yet, the official line appears to be that all failures should be provided a safety net by the government. We need to take heed of the advice of the quintessential central banker Paul Volcker who, contrary to the mainstream view, argues that banks/ institutions should be allowed to fail. While allowing such failures, the regulatory authorities need to put in the public domain early warnings and penalties should be widely publicised. Such an approach will nip the problem in the bud long before the “too big to fail” issue comes up where the authorities have little choice but to bail-out the failing bank/ institution.

It is recognised that early monetary tightening is the need of the hour. There should be a better appreciation of the role of monetary policy in tackling inflation. This will require an accord between the government and the RBI, which should be put in the public domain. There is a need for coordination between monetary policy and regulation. Regulation can be an effective tool for handling asset price inflation by varying regulatory stipulations over the cycle, while bearing in mind certain minimum standards of regulation, which need to be observed in all phases of the cycle. Regulation needs to be light and supervision needs to be punctilious. The issue of whether regulation /supervision should be lodged in the central bank or in a separate organisation is a debate on which the jury is still out. Supervisors have to develop skills well beyond those who are supervised and the supervisor has to develop a “‘killer instinct”, once violations are conclusively established. Under such a system, violation of the regulatory system will be rare, especially if it is perceived that violations invite severe penalties, which are imposed proximate to the time of violation. This will require a quantum jump in the quality of regulation and supervision.