Monetary Policy: RBI takes charge

Monetary Policy: RBI takes charge*

M G Warrier

PREAMBLE of the Reserve Bank of India mandates the central bank  

“to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in ² [India] and generally to operate the currency and credit system of the country to its advantage”

Prior to the establishment of the Reserve Bank, the Indian financial system was totally inadequate on account of the inherent weakness of the dual control of currency by the Central Government and of credit by the Imperial Bank of India.

The Hilton-Young Commission, therefore, recommended that the dichotomy of functions and division of responsibility for control of currency and credit and the divergent policies in this respect must be ended by setting-up of a central bank – called the Reserve Bank of India – which would regulate the financial policy and develop banking facilities throughout the country. Hence, the Bank was established with this primary object in view.

Another objective of the Reserve Bank has been to remain free from political influence and be in successful operation for maintaining financial stability and credit. The fundamental object of the Reserve Bank of India is to discharge purely central banking functions in the Indian money market, i.e., to act as the note- issuing authority, bankers’ bank and banker to government, and to promote the growth of the economy within the framework of the general economic policy of the Government, consistent with the need of maintenance of price stability.

A significant object of the Reserve Bank of India has also been to assist the planned process of development of the Indian economy. Besides the traditional central banking functions, with the launching of the five-year plans in the country, the Reserve Bank of India has been moving ahead in performing a host of developmental and promotional functions, which are normally beyond the purview of a traditional Central Bank.

The above background becomes relevant in the context of certain unprecedented developments like retail inflation overshooting the given target  of 4 (+)/(-) 2 percent being chased by RBI by more than one percent and RBI experimenting new alternatives for improving liquidity in the system and being transparent in seeking fiscal policy support while doing its best in policy areas where the central bank is in charge. To be factual, retail inflation was. 7.59 percent for January 2020, higher by 24 basis points from 7.35 percent reached in the previous month. MPC sees CPI inflation at 6.5 percent for January-March 2020 and 5.4-5 percent for April-September 2020. Chief Economic Advisor Krishnamurthy Subramanian agrees with RBI’s realistic assessment of inflation trajectory and is optimistic about headline inflation converging back to core inflation at 4.2-4.5 percent by July-August, 2020.

On February 6, 2020, after the usual three-days deliberations RBI’s Monetary Policy Committee (MPC), opted for retaining the base rates unchanged. For some time now, the central bank’s bank rate has not been having much influence on interest rates in the financial market. Media and the analysts have been camouflaging this trend by phrases like ‘market had already factored in the change’ or ‘it takes some time to percolate the impact to ground level’. In reality, this tool has lost the influence it had on the rate of ‘rent’ on resources till the beginning of last decade. This is not to underplay the significance of MPC’s professional assessment of the influence of developments in the economy on inflation-related issues. Definitely, the periodic assessments should serve as accelerator and brake in policy formulation.

Equally important is the statement setting out various developmental and regulatory policy measures for strengthening regulation and supervision; broadening and deepening of the financial markets; and enhancing customer education, protection and financial inclusion, issued by RBI simultaneously with the Monetary Policy Statement.

The introductory observation in the Monetary Policy Statement issued by RBI on February 6, 2020 reads:

“On the basis of an assessment of the current and evolving macroeconomic situation, the Monetary Policy Committee (MPC) at its meeting today (February 6, 2020) decided to:

• keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 5.15 per cent.

Consequently, the reverse repo rate under the LAF remains unchanged at 4.90 per cent and the marginal standing facility (MSF) rate and the Bank Rate at 5.40 per cent.

• The MPC also decided to continue with the accommodative stance as long as it is necessary to revive growth, while ensuring that inflation remains within the target.

These decisions are in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4 per cent within a band of +/- 2 per cent, while supporting growth”.

In his address at St Stephen’s College, New Delhi on January 24, 2020, RBI Governor Shaktikanta Das dwelt in great detail the evolution of monetary policy in India (See Box for excerpts covering the period 2016 onwards).  Concluding the speech,  he said: 

“Monetary policy frameworks in India has thus evolved in line with the developments in theory and country practices, the changing nature

of the economy and developments in financial markets. Within the broad objectives, however, the relative emphasis on inflation, growth and financial stability has varied across monetary policy regimes. Although global experience with financial stability as an added policy objective is still unsettled, the Reserve Bank has always been giving due importance to financial stability since the enactment of the Preamble to the RBI Act. The regulation and supervision of banks and non-bank financial intermediaries has rested with the Reserve Bank and has kept pace with the prescribed global norms over time. More recently, the focus of financial stability has not only confined to regulation and supervision but also extending the reach of formal financial system to the unbanked and unserved population.

Apart from financial inclusion, there is also a focus on promoting secured, seamless and real-time payments and settlements. This renewed focus on financial inclusion and secured payments and settlements are not only aimed at promoting the confidence of general public in the domestic financial system but also improving the credibility of monetary policy for price stability, inclusive growth and financial stability.

Joint effort by RBI and GOI to manage liquidity

While committing that efforts are on from government’s side to the covenants of the Fiscal & Budget management Act (FRBM) by containing fiscal deficit to agreed levels, responding to a debate in Parliament, Finance Minister Nirmala Sitharaman said that Centre is giving equal importance to all the four growth engines, namely,  public investment, private investment, consumption and export. In support, she listed measures such as lowering corporate tax, removing dividend distribution tax, reducing Goods & Services Tax (GST) on electric vehicles, amending the Insolvency & Bankruptcy Code (IBC) forfaster disposal of cases and amalgamation of 10 public sector banks into four. Let us be optimistic about government’s will to mainstream and deploy nation’s domestic assets including equity investments in PSUs for promoting economic growth. One also expects productive use of all reserves including foreign exchange reserves to fetch reasonable return on investments, without depleting their real value.

RBI on its part, has become more active in deploying all weapons of monetary policy management in its armour more judiciously and on an ongoing basis. To support lending to auto, housing and MSME sectors, RBI has given exemption from the requirement to maintain 4 percent CRR (Cash Reserve Ratio) on deposits equivalent to the incremental loans disbursed by banks to these sectors. The exemption will be effective from the fortnight ended January 31, 2020. The first special lending window with this facility will be open till July 31, 2020. Under the Liquidity management Framework, RBI will also be using instruments like fixed and variable rate repo/reverse repo auctions, outright OMOs, forex swaps and other instruments from time to time.

*A slightly edited version was published in The Global Analyst, March 2020
M G Warrier
Blog 5087
March 9, 2020

Box : Excerpts from the address by RBI Governor Shaktikanta Das at St Stephen’s College, New Delhi on January 24, 2020 (Source: RBI Website)

2016 onwards: Flexible Inflation Targeting

17.Amid this, a Monetary Policy Framework Agreement (MPFA) was signed between the Government of India and the Reserve Bank on February 20, 2015. Subsequently, flexible inflation targeting (FIT) was formally adopted with the amendment of the RBI Act in May 2016. The role of the Reserve Bank in the area of monetary policy has been restated in the amended Act as follows: “the primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth”.

18. Empowered by this mandate, the RBI adopted a flexible inflation targeting (FIT) framework under which primacy is accorded to the objective of price stability, defined numerically by a target of 4 per cent for consumer price headline inflation with a tolerance band of +/- 2 per cent around it, while simultaneously focusing on growth when inflation is under control. The relative emphasis on inflation and growth depends on the macroeconomic scenario, inflation and growth outlook, and signals emerging from incoming data. Since then RBI has been conducting monetary policy in a forward-looking manner and effectively communicating its decisions to maintain inflation around its target and thereby to support growth. At the same time, RBI is also fine-tuning its operating procedures of monetary policy for effective policy transmission across the financial markets and thereby onto the real economy. As an outcome, inflation has fallen successively and has averaged below 4 per cent since 2017-18, notwithstanding recent up-tick in inflation driven by food prices, especially the sharp increase in vegetable prices reflecting the adverse impact of unseasonal rains and cyclone.

Evolution of monetary policy in line with the changing Theoretical Developments and International Best Practices

19. The monetary policy framework in India has also been guided by developments in theory and international best practices. For instance, the collapse of the Bretton-Woods system of fixed exchange rates and high inflation in many advanced economies during the 1970s provided the necessary background to the choice of money supply as a nominal anchor. Since the late 1980s, however, experience of many advanced countries with monetary targeting framework was not satisfactory inter alia due to growing disconnect between monetary aggregates and goal variables such as inflation. A similar instability in money demand function was also evidenced in the Indian context in the 1990s which led to a shift from monetary targeting to multiple indicators approach in 1998.

20. Since early 1990s, beginning with New Zealand in 1990, many advanced and emerging market economies (EMEs) have switched to inflation targeting as the preferred policy framework. India, however, formally adopted the framework in 2016 which has helped us in terms of learning from the experiences of a diverse set of countries over a long period of time. In fact, the post-global financial crisis experience questioned the relevance of narrow focus on price stability as the sole

objective of monetary policy, which called for adoption of a flexible approach to inflation targeting to achieve macro-financial stability. In this milieu, financial stability has emerged as another key consideration for monetary policy, though jury is still out as to whether it should be added as an explicit objective. It is interesting to note that the central banking function as the lender of last resort (LOLR) has remained intact, notwithstanding the developments and refinements in the policy frameworks across countries, including India.

Evolution of monetary policy in line with the financial market developments

21. Financial markets play a critical role in effective transmission of monetary policy impulses to the rest of the economy. Monetary policy transmission involves two stages. In the first stage, monetary policy changes are transmitted through the money market to other markets, i.e., the bond market and the bank loan market. The second stage involves the propagation of monetary policy impulses from the financial market to the real economy - by influencing spending decisions of individuals and firms. Within the financial system, money market is central to monetary operations conducted by the central bank.

22. In the case of India, money market prior to the 1980s was characterised by paucity of instruments and lack of depth. Owing to limited participation, money market liquidity was highly skewed, characterised by a few dominant lenders and a large number of chronic borrowers. In the presence of ad hoc Treasury Bills with fixed interest  rate under the system of automatic monetisation, Treasury Bills could not emerge as a short-term money market instrument. Administered interest rates and captive investor base in government securities market further impeded open market operations as an ineffective instrument of monetary control. The prevalence of interest rate regulations along with restrictions on participation prohibited the integration of different market segments which is a prerequisite for effective monetary policy transmission. In this environment, monetary policy initially relied mainly on credit planning and selective credit controls and eventually on monetary targeting through quantitative instruments

23. Financial markets reforms since the early 1990s, therefore, focused on dismantling various price and non-price controls in the financial system to facilitate integration of financial markets. Reform measures encompassed removing structural bottlenecks, introducing new players/instruments, ensuring free pricing of financial assets, relaxingquantitative restrictions, strengthening institutions, improving trading, clearing and settlement practices, encouraging good market practicesand promoting greater transparency. These reforms gradually facilitated the price discovery in financial markets and interest rate emerged as a signaling mechanism. This paved way for introduction of the Liquidity Adjustment Facility (LAF) in 2000-01 as a tool for both liquidity management and also a signalling device for interest rates in the overnight money market. Amid greater integration of domestic financial markets with global markets, subsequently, the RBI also began to recognise the impact of global developments on domestic monetary policy.The developments in financial markets enabled the Reserve Bank to use market-based instruments of monetary policy and utilise the forward-looking information provided by financial markets in the conduct of monetary policy under the multiple indicators approach.

24. Although various segments of financial markets had acquired depth and maturity over time, a key challenge has been on fuller and faster transmission of policy rate changes not only to money market segments but also to the broader credit markets. In order to address these challenges, the Reserve Bank has been trying different models. At the same time, the liquidity management framework was also fine-tuned since April 2016 with the objective of maintaining the operating target close to the policy rate. Under this framework, the Reserve Bank assured the market to meet its durable liquidity requirements while fine-tuning its operations to make short-term liquidity conditions consistent with the stated policy stance. This was achieved through a variety of instruments including fixed and variable rate repo/reverse repo of various maturities, the marginal standing facility (MSF) and outright open market operations – complemented at times by the cash management bills and foreign exchange swaps.

Challenges in the Current Context

25. One of the major challenges for central banks is the assessment of the current economic situation. As we all know, the precise estimation of key parameters such as potential output and output gaps on a real time basis is a challenging task, although they are crucial for the conduct of monetary policy. In recent times, shifting trend growth in several economies, global spillover effects and disconnect between the financial cycles and business cycles in the face of supply shocks broadly explain why monetary policy around the world is in a state of flux. Nonetheless, a view has to be taken on the true nature of the slack in demand and supply-side shocks to inflation for timely use of counter cyclical policies.

26. We, in the Reserve Bank, therefore, constantly update our assessment of the economy based on incoming data and survey based forward looking information juxtaposed with model-based estimates for policy formulation. This approach helped the Reserve Bank to use the policy space opened up by the expected moderation in inflation and act early, recognizing the imminent slowdown before it was confirmed by data subsequently. Monetary policy, however, has its own limits. Structural reforms and fiscal measures may have to be continued and further activated to provide a durable push to demand and boost growth. In my previous talks elsewhere, I have highlighted certain potential growth drivers which, through backward and forward linkages, could give significant push to growth. Some of these areas include prioritising food processing industries, tourism, e-commerce, start-ups and efforts to become a part of the global value chain. The Government is also focusing on infrastructure spending which will augment growth potential of the economy. States should also play an important role by enhancing capital expenditure which has high multiplier effect.