The conduct of monetary policy is not based on simplistic binaries, particularly during times of extraordinary uncertainty
The conduct of monetary policy in India has been critiqued by economists in recent weeks. The following are some of the perceived lacunae. One, that there has been an unwarranted delay in shifting priority from supporting growth to controlling inflation. The latter is anyway the primary objective of the Monetary Policy Committee (MPC) given its mandate as a (flexible) inflation targeting institution. Two, that policy has been pursuing multiple objectives, in addition to balancing the inflation-growth trade-off, resulting in a loss of focus on the primary objective of price stability, preventing a timely response to persistently high inflation. As a corollary, a disconnect, even dissonance, has emerged between statements and actions, hindering clear communication and forward guidance to markets.
Each of these issues is complex in itself; combined, exponentially so. This article attempts to provide a brief overview of the underlying challenges in the conduct of monetary policy, particularly in view of the extreme macroeconomic uncertainties which have characterised the previous years.
First, on inflation targeting. Monetary policy is always a forward-looking exercise, based on forecasts. The median forecast for the one-year ahead consumer price index inflation in the Reserve Bank of India’s Survey (RBI) of professional forecasters moved lower from 4.9 per cent in the September 2021 round to 4.7 per cent in January 2022. Note that this drop itself can be interpreted to mean that inflation targeting credibility was being factored into the forecasts. It was only in the March 2022 round that this jumped to 5.2 per cent, once the geo-economic impacts of the Ukraine crisis on commodities and energy prices had begun to be factored in. The first response to this rise was the de facto tightening in the April 2022 MPC review, with the rate floor of the policy corridor raised to 3.75 per cent with a switch to the standing deposit facility (SDF) from the earlier reverse repo. One of the reasons for the switch was to impart greater flexibility in policy operations, since the SDF is a non-collateralised instrument to absorb excess liquidity.
Note that the width of the policy corridor — repo minus reverse repo — has itself emerged as an additional monetary policy tool. Calibrating the width provides room for moving the operating rate (the weighted average call rate) to a desired level within the corridor, depending on the prevailing level of systemic liquidity. Liquidity levels are managed via open market operations (OMOs) and other channels to keep very near-term interest rates close to the operating rate.
The second concern is fiscal dominance of monetary policy. Transmission of monetary policy signals into the spectrum of interest rates are varied, with each rate having different behavioural, regulatory and structural causes for the changes as well as functional impacts.
In the conventional framework, the role of monetary policy is to fix the policy rate at a level deemed appropriate for the prevailing and expected macroeconomic conditions. The rest of the yield curve, which is anchored at the operating rate, is allowed to move based on market and economic conditions, without monetary policy attempting to control the slope and curvature. Of course, this conventional view has long since been mostly abandoned by global central banks with the dominance of unconventional monetary policy since the global financial crisis, with the policy rate at the zero lower bound. Various instruments like quantitative easing, yield curve control, etc had been deployed to change the structure of the yield curve.
In India too, during the pandemic phase, the RBI had deployed programmes like targeted long-term repo operations, G-sec Acquisition Programme over and beyond normal open market operations to influence the yield curve at selected maturities. Had these instruments, including the levels of surplus liquidity, interfered with the conduct of policy? Not really. For one, these liquidity injecting measures had already been stopped since September 2021 (much before any of the G-10 central banks had even begun to signal any eventual shrinking of their own balance sheets). At the shorter end of the rates spectrum, market rates had already started to rise beginning with the set of non-policy rate signals (via variable rate reverse repo and T-bill auctions) since October 2021. These short-term rates are the real drivers of transmission to banks’ deposit and lending rates, which have both risen significantly, starting even before the formal rate hikes started with the hike in SDF rate in April 2022.
Relating to the move up in short-term rates and liquidity management was the implicit forward guidance on a normalisation process using cut-off and average yields during October and November 2021. This enabled a remarkably orderly move up in short-term rates to close to the then repo rate, without significantly disrupting longer-term yields. Rates of shorter-term funding instruments – T-bills, commercial paper, bank certificates of deposits — had also moved up in tandem.
A third concern is whether RBI’s “management” of the rupee — or at least its volatility — was distracting from the primary objective of price stability. The opinion of experts on whether foreign exchange markets intervention is desirable vary. Yet, India is currently facing an episode of the open economy impossible trinity. The capital account is largely open, led by portfolio capital flows. The rupee is mostly flexible, responding to various external stimuli, for example the US dollar strength, Chinese renminbi, and overall foreign currency flows. Control of domestic interest rates is needed to squeeze domestic aggregate demand. The only option for domestic policy control in this trilemma is to manage the exchange rate.
To bolster this argument, a recent BIS survey of Asian central banks (simplistically stated), indicated that the financial channels dominating global spill-over effects of G-10 central bank actions amplify the effects of domestic shocks, requiring foreign exchange intervention.
Paraphrasing Olivier Blanchard, monetary policy is a science, but policy-making is an art. How difficult this art is is evident even in the responses of the G-10 central banks, which have access to much better, granular data and surveys for their respective economies. The central lesson is that better economic information is crucial for policy decisions.The writer is executive vice-president and chief economist, Axis Bank. The views are personal