Price and Financial Stability: Managing
Complementarities and Trade-Offs

Plenary Address by Shri Shaktikanta Das, Governor
Reserve Bank of India

Delivered at the Kautilya Economic Conclave Organised by
the Institute of Economic Growth and Ministry of Finance,
Government of India,

New Delhi; October 20, 2023

I am delighted to be back at the Kautilya Economic Conclave,
2023. This event is emerging as a leading forum for well-rounded
discourse on economic and other policy issues of contemporary
relevance. I am sure the eminent gathering here will contribute richly
to the discussions on issues and challenges that confront us today

and tomorrow.

2. In the opening line of my latest Monetary Policy Statement on
October 6, 2023, I had referred to Kautilya's emphasis on stability in

the macroeconomic context. I now propose to share my thoughts on
managing the complementarities and trade-offs associated with price
and financial stability. I also propose to touch upon the policy mix to
achieve these desirable goals, and our experience in dealing with
these issues in India. Evidently, the choice of this topic draws

inspiration from the nomenclature of this economic conclave.

3. But let me first begin by commenting on the current global
context. The global economy is facing a triad of challenges - (i) slow
moderation in inflation which is getting interrupted by recurring and
overlapping shocks; (ii) slowing growth, and that too, with fresh and

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enhanced obstacles; and (iii) lurking risks of financial instability.
Central banks with price stability as their primary objective have
raised policy rates aggressively, while signalling to keep rates higher
for longer. Some of them have taken a pause on rate hikes. Financial
stability concerns along with other factors, have conditioned this
pursuit, following the recent banking sector turmoil in some advanced
economies. Financial markets have become highly sensitive to every
piece of new information. Policy making has become extraordinarily
complex amidst such confluence of factors. Increasingly, central
bankers face tensions between doing too little or doing too much.
While several central banks may prefer the prudence of overkill,
somewhat embodied in higher for longer policy stances, financial
instability risks rise up to restrain them. With every shock such as the
recent simultaneous surge of crude oil prices, bond yields and the
US dollar, additional dimensions of policy dilemma present

themselves and hamstring their responses.

4. _Insucha situation, conflict may arise between the requirements
of price and financial stability, but policymakers have to deftly tread
a fine balance, as it is important to recognise that price and financial
stability reinforce each other in the medium to long term. Stability is
the foundation of sustained progress. As Kautilya explained long ago:
"Which is preferable - an immediate small gain or a large gain in the
future? A large gain in the future is preferable if it is like a seed

yielding fruit in the future."" Against this background, let me start with

'1 Kautilya - The Arthashastra by L. N. Rangarajan, Penguin, 1992.

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the evolution of the idea of price and financial stability in the global

context.

Global Backdrop: Evolution of Price and Financial Stability

5. The role of central banks had evolved by the 19" century, as
they came to be recognised primarily as the lender of last resort
(LOLR) (Bagehot, 1873).2 The LOLR principle remains the
cornerstone of modern central banking and its scope has widened
over time to encompass financial stability in respect of financial
markets and institutions. Historically, therefore, financial stability has
been the core remit of central banks involving both prevention and

management of financial crisis.

6. By the second half of the 20" century, inflation surges world-
wide caused by post-war fiscal activism and recurring oil price
shocks, in the backdrop of stagnating economic activity, resulted in
price stability being recognised as the prime objective of central
banks. As inflation targeting gained ground from the early 1990s, a
widely accepted view emerged that monetary policy should primarily
- or perhaps solely - focus on price stability, with financial stability
falling in the domain of prudential regulation and supervision. Price
stability was increasingly seen as the best guarantee of financial

stability.

2 Lombard Street: A Description of the Money Market by Walter Bagehot.

7. IThe extended period of steady growth and low and stable
inflation during the Great Moderation era of 1990s and early 2000s
lulled central banks into a sense of complacency with regard to
regulation and supervision of the financial system. Quietly and in
parallel, the seeds of financial instability were germinating. Soon,
therefore, the conventional wisdom of price stability being an
automatic stabiliser of the financial system got wiped off in favour of
the view that price stability on its own would not necessarily
safeguard financial stability. This view was further reinforced by the
global financial crisis (GFC) of 2008.° Governor Subbarao (2012)
acknowledged this stating that "The global financial crisis followed by
the euro zone debt crisis has changed the theology of central banking
in a fundamental way. The orthodoxy of central banking before the
2008 crisis was: single objective - price stability; single instrument -
short-term interest rate. ...The crisis came as a powerful rebuke to
central banks for having neglected financial stability in their single-

minded pursuit of price stability."4

8. During the GFC, central banks globally undertook large scale
monetary stimulus to depress interest rates to ultra-low levels and
rekindle animal spirits among investors and households. These

measures were aimed at restoring financial stability in the near term,

3 Several reasons were ascribed to the occurrence of GFC. One reason was high household
indebtedness, particularly in advance economies which rose to unsustainable levels because
of leverage, resulting in the US sub-prime mortgage crisis and the European debt sustainability
crisis.

4 Subbarao, D. (2012), "Price Stability, Financial Stability and Sovereign Debt Sustainability
Policy Challenges from the New Trilemma'", February.

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but ended up threatening future price stability, thus posing an inter-
temporal tradeoff between price and financial stability. In other
words, the large scale monetary and fiscal accommodation
undertaken to address financial stability risks during the GFC sowed
the seeds of inflationary pressures in subsequent years. In the
meantime, central banks had become more proactive on issues of

financial stability.

9. Central banks again faced a trade-off between price and
financial stability during the COVID-19 pandemic as economic
activity came to a standstill amidst elevated global commodity prices
and disruption of supply chains. As the global financial system
became awash with stimulus-injected liquidity, concerns were raised
about the implication of the liquidity glut for price stability. With the
commencement of the war in Ukraine, these concerns materialised
and inflation surged to 40-year high levels. The unprecedented rate
hikes, which was undertaken by central banks, have resulted in large
erosion in profitability of some banks in advanced economies.
Obviously, these banks had not adequately factored in the interest
rate risks associated with a reversal of the accommodative policy
stance pursued during the pandemic. The collapse or failure of some
of these banks demonstrated the reverse causality of the trade-off
mentioned earlier. In other words, the measures undertaken during
the GFC to restore financial stability sowed the seeds of future price
instability risks; while this time around after the pandemic and the
war, the measures to address price stability led to concerns relating

to financial instability in some parts of the world.

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10. Summing up, the last two decades have revealed multiple
linkages running between financial stability to price stability and vice
versa. Measures for promoting financial stability can complement or
constrain monetary policy depending upon its usage. Financial
stability measures aimed at effective regulation and supervision of
banks, non-banking financial companies (NBFCs) and markets can
enhance monetary transmission and help achieving price stability;
whereas financial stability measures via extraordinary monetary
expansion, if not corrected timely, can jeopardise price stability.
Similarly, the linkage from price to financial stability also operates in
two ways. First, extended period of low and stable inflation could lead
to financial instability through complacency loop as explained earlier;
and prolonged periods of depressed growth can keep prices in
check, but they could also lead to financial instability. Second,
periods of high inflation that are addressed by strong monetary policy
tightening can deter financial stability if interest rate risks are not
adequately factored in. It is, therefore, evident that the relationship
between price stability and financial stability depends upon the policy

choices that we make.

The Indian Experience
11. The Reserve Bank, with its assigned responsibility to maintain

monetary stability and price stability, also has the larger

> The preamble to the RBI Act 1934 describes RBI's main functions as: "....... 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; to
have a modern monetary policy framework to meet the challenge of an increasingly complex
economy, to maintain price stability while keeping in mind the objective of growth."

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responsibility of maintaining financial stability, as it is the regulator
and supervisor of banks and other financial sector entities and
markets. Unlike price stability, financial stability is not specifically
defined and not explicitly quantifiable. As a result, it has been
interpreted subjectively specific to the context and circumstances.
Governor Y.V. Reddy defined financial stability in central banking
parlance as "Financial Stability refers to the smooth functioning of the
financial markets and institutions, (it) does not mean absence or
avoidance of crisis but presence of conditions conducive to efficient

functioning without serious disruption.®

Recent Years

12. This unique combination of Reserve Bank's responsibilities -
monetary policy combined with macroprudential regulation and
micro-prudential supervision - has enabled the Reserve Bank to
focus on both financial and price stability, even during the recent
years of multiple, overlapping and unprecedented shocks, coming
one after the other. I am referring to the post ILFS crisis, COVID-19
pandemic, war in Ukraine, unparalleled tightening of interest rates

and financial market volatilities, in that order.

13. Following the collapse of ILFS in the second half of 2018,
almost the entire 2019 necessitated taking measures to intensify the

supervision of NBFCs; close monitoring of their liquidity and stability

® Reddy Y.V. (2006), "Financial Sector Reform and Financial Stability', speech delivered at
8th Global Conference of Actuaries, Mumbai, March 10.

conditions; infusing system liquidity through innovative instruments
like currency buy-sell swaps; restoring market confidence through
appropriate communication and backing it up with actual action on

several fronts.'

14. When the COVID-19 pandemic scarred the global economy
including India, our response was swift and decisive. We put in place
business continuity measures even before the nation-wide lock down
was announced.? The policy repo rate was reduced sizeably by 115
bps in a span of two months (March-May 2020). Unlike advanced
economy central banks which eased rates close to the zero-lower
bound, we did not reduce the policy repo rate below our inflation
target of 4 per cent. Financial conditions were eased substantially by
further reducing the reverse repo rate, which lowered the floor rate of
the Reserve Bank's liquidity adjustment corridor. This became the

effective anchor of money market rates.

15. In addition, liquidity enhancing measures equivalent to 8.7 per
cent of GDP were announced. Our liquidity measures were unique in
several ways: liquidity was provided only through the Reserve Bank's
counterparties (banks); asset purchase programme (G-SAP) was for

a limited period of six months; collateral standards were not diluted

7 In June 2019, during the post policy press conference, I had said clearly that "...it is our
endeavour to ensure that there is no collapse of any large systemically important NBFC or
any large NBFC. And, in that direction we are monitoring the evolving situation and we will
see how it moves forward. ...."

8 We were perhaps amongst the first few central banks to have set up a special quarantine
facility with about 200 officers, staff and service providers, engaged in critical activities to
ensure business continuity in banking and financial market operations and payment systems.

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while offering lending facilities; and most of these liquidity injection
measures were targeted and had pre-announced sunset clauses,
which helped in their orderly unwinding. In parallel, macroprudential
measures like moratorium on repayment of bank and NBFC loans for
six months, followed by Resolution Frameworks for COVID-19
stressed assets were also announced. These resolution frameworks
were offered for a limited period and were not open ended, but
subject to achievement of certain financial and operational

parameters.

16. It may be noted that all these measures were nuanced, keeping
in mind the price and financial stability challenges they may create in
the future. Interestingly, the Reserve Bank's balance sheet size
which had expanded to 28.6 per cent of GDP in 2020-21 from 24.6
per cent in 2019-20, has moderated to about 22.5 per cent in 2022-

23, going below its pre-pandemic level.°

17. During 2021, the surplus liquidity was gradually migrated from
the short end to the longer horizon through variable rate reverse repo
(VRRR) auctions of longer tenors, which lifted short-term rates from
ultra-low levels, thereby obviating financial stability challenges. This
was done by sensitising the market well in advance through effective

communication.

2 As on October 13, 2023, the balance sheet size was Rs.63.5 lakh crore and based on the
estimated nominal GDP of Rs.301.8 lakh crore in Union Budget 2023-24, the balance sheet
size to GDP ratio is placed at 21.0 per cent.

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18. The period since the onset of the pandemic was an example of
how the Reserve Bank could effectively address macro-stability
consideration of maintaining price stability through conventional and
unconventional monetary policy, within the flexibility provided by the
flexible inflation targeting (FIT) framework, while also addressing
financial stability considerations simultaneously. The flexibility
provided by a dual mandate under FIT of maintaining price stability
while keeping in mind the objective of growth, along with the
provision of a tolerance band around the target rate, helped us to
accommodate large supply side shocks, while focusing on immediate

growth concerns during the pandemic.

19. Subsequently, when the shock of Ukraine war struck in 2022
and there was a sudden surge in inflation, we quickly changed gears
by prioritising inflation over growth and shifting the monetary policy
stance from being accommodative to withdrawal of accommodation.
Further, given that the nature of inflation process in India was driven
largely by supply side shocks, proactive supply side measures taken

by the Government aided to temper the price impulses.

The Current Context

20. After raising the policy repo rate by 250 bps cumulatively
between May 2022 and February 2023, with the quantum of rate
hikes being calibrated in tune with the evolving inflation outlook, we
have maintained pause on policy rates in 2023-24 so far. The 250-

bps hike is still working through the financial system. We have also

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appropriately fine-tuned our communication to ensure successful

transmission of the rate hikes.

21. In the prevailing global environment of slowing growth and
stubborn inflation, especially in the last few miles before reaching the
target, economic activity in India exhibits resilience on the back of
strong domestic demand.'? Real GDP growth for 2023-24 is
projected at 6.5 per cent and India is poised to become the new

growth engine of the world.

22. We remain extra vigilant on the evolving inflation dynamics.
Headline CPI inflation has moderated sharply to 5.0 per cent in
September 2023 with correction in vegetable prices. The outlook on
food inflation, however, is beset with uncertainties. On the positive
side, core inflation (i.e., CPI excluding food and fuel) has eased by
around 170 basis points to 4.5 per cent from its recent peak in
January 2023. We have projected headline CPI inflation at 5.4 per
cent for 2023-24. As evident from our survey of September 2023,
there is further progress on anchoring of inflation expectations which
entered single digit zone for the first time since the COVID-19
pandemic. In the current situation, monetary policy must remain
actively disinflationary to ensure that ongoing disinflation process

progresses smoothly.

1° Real gross domestic product (GDP) posted a growth of 7.8 per cent year-on-year (y-o-y) in
Q1:2023-24. Gross fixed capital formation rose by 8.0 per cent and private consumption by
6.0 per cent in Q1. On the supply side, real gross value added (GVA) also rose by 7.8 per cent
in Q1:2023-24, powered by 10.0 per cent increase in services sector.

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23. On the financial stability front, throughout the multiple shocks in
the recent period, the Reserve Bank has adopted a prudent approach
and taken several initiatives to revamp regulation and supervision of
banks, NBFCs and other financial entities by developing an
integrated and harmonized architecture. The Indian financial sector
has been stable and resilient, as reflected in sustained growth in
bank credit backed by improved asset quality, adequate capital and
liquidity buffers and robust earnings growth.'' Macro stress tests for
credit risk reveal that scheduled commercial banks (SCBs) would be
able to comply with the minimum capital requirements even under
severe stress scenarios. The financial indicators of NBFCs are also
in line with that of the broader financial system as per June 2023
data. There is, however, no room for complacency because it is
during good times that vulnerabilities may creep in; hence, buffers
are best built up during good times. Banks, NBFCs and other
financial sector entities should remain vigilant and complete the
pending repairs, if any, to their houses. Roofs need to be fixed, walls
need to be further strengthened and foundations need to be
augmented when the weather is good to withstand potential adverse

weather events in the future.

1 All key indicators of asset quality and stress of scheduled commercial banks (SCBs)
continue to improve on a sustained basis. Provisional data as of June 2023 indicate that gross
non-performing assets (GNPA) and net non-performing assets (NNPA) ratios declined to a
decadal low of 3.6 per cent and 0.9 per cent, respectively. Capital adequacy ratio (CRAR) of
SCBs increased to 16.9 per cent in June 2023 from 16.2 per cent in June 2022.

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Conclusion

24. Let me now conclude. Price stability and financial stability
complement each other. In fact, price stability is an anchor for
financial stability, but the trade-off between the two becomes a close
call at times. It has been our endeavour to manage these
complementarities and trade-offs as efficiently as possible. While
according priority to price stability keeping in mind the objective of
growth, as mandated under the law, we treat financial stability as
non-negotiable. Our policies and choices of instruments are guided
by this holistic approach. We have strengthened our macroeconomic
fundamentals and buffers, and these are imparting resilience to the
economy to withstand large shocks and navigate in an increasingly
turbulent and uncertain global setting. Alan Greenspan, the former
Fed Chair, once said, "More fundamentally, an environment of
greater economic stability has been key to the impressive growth in
much of the world.""? India's economic performance in recent years

lends credence to this view.

Thank You. Namaskar.

? Remarks by Mr. Alan Greenspan, November 14, 2005.

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