As sweet cometh the hour, cometh the policy, whether clothed as inflation targeting, recession fighting or financial sector stabilising. What the conduct of the central bank has shown in the recent past is that whatever the nominal rigidity in the objective of monetary policy conduct, the policy, in practice, flexibly targets the immediate problem at hand. While the bimonthly setting of policy rates continues as a ritual, open market operations to increase or lower the supply of liquidity and correspondingly bend rates lower or higher and manoeuvres such as Operation Twist to alter short- and long-term rates make repo rates far less critical than they ought to be in a strict inflation-targeting model. And this is all to the good.
In a world of high levels of capital mobility across borders, financial stability is a very major consideration. Fiscal policy, monetary policy, exchange rate policy, export and import policy and capital controls must all move together to the choreography of macroeconomic stability in such a world. This is more than a little beyond simple-minded inflation targeting. The remarkable thing is that these individual policies have, indeed, been dancing as a practised ensemble, without necessarily being conscious of the coordination one has with another. Therefore, it matters little if the government retains the fiction that the goal of monetary policy is inflation targeting or not. More than setting policy rates, what must preoccupy the central bank is developing the market for corporate debt, complete with all the instruments required to mitigate the assorted risks that accompany the bond market.
Managing supply constraints is beyond the task of monetary policy. Whether the supply is of food commodities or of energy, policy would need to look through their first round price impact. The good news is that India’s monetary policy has been far less dogmatic than labels for methodology suggest. Inflation forecasting must become more realistic, however, to avoid unrealistic expectations sending policy rates too high.
This piece appeared as an editorial opinion in the print edition of The Economic Times.