Michael Debabrata Patra: Lost in transmission? financial markets and
monetary policy
Speech by Dr Michael Debabrata Patra, Deputy Governor of the Reserve Bank of India,
in the Treasury Heads' Seminar, organised by the Reserve Bank of India, Lonavala, 12
November 2022.
* * *
Valuable comments received from Sitikantha Pattanaik, K M Kushwaha, Dimple
Bhandia, Ashish Saurabh and editorial help from Vineet Kumar Srivastava and Samir
Ranjan Behera are gratefully acknowledged.
I thank you all for your very valuable participation in this seminar, the third in the series
that we began in May 2016. In this context, I want to thank our team in the Financial
Markets Regulation Department for making this Seminar happen with physical
interactions after a long gap. Given my abiding interest in financial markets, I am
particularly grateful to our team for ensuring that I don't miss this opportunity to be with
treasury heads and financial market experts. Although there are other opportunities for
us in the Reserve Bank to interact with all of you collectively and individually, this forum
is special. It provides a unique opportunity for us to hear from you on issues of current
and evolving relevance for making our markets more resilient and vibrant in serving the
needs of a modernising economy.
A distinction is made between morality on how we evaluate ourselves and ethics or how
we assess others in relation to us. In the rest of my talk, I will be ethical on two planes -
your interactions with each other; and, how you appear to us, your admirers. I request
your indulgence, if only to while away the time till lunch.
A conference of the heads of treasuries is pre-destined to be cloaks and daggers, or
smoke and mirrors, if you will - everything that is emitted here is either in the money or
out of it. In the public's imagination, your interactions here with each other even on an
informal basis can be stylised to follow a game theoretic sequence. To give you a sense
of the thrust and parry that could be characterising your conversations in the
layperson's fantasy - imagine that two persons are arrested: let's call them A and B.
Each is held in solitary confinement with no means of communicating with the other.
The prosecutors do not have the evidence to convict the pair. So, they offer each of
them the opportunity to either betray the other by testifying that the other committed the
crime or cooperate by remaining silent.
The question is: what will be the outcome? You have four options:
Option 1: Both A and B betray each other, and prosecutors' plea will be that each
serves five years in prison.
Option 2: A betrays B but B remains silent; so prisoner A is set free and prisoner B
serves 10 years in prison.
Option 3: B betrays A but A remains silent; so prisoner B is set free and prisoner A
serves 10 years in prison.
Option 4: Each remains silent, and so prosecutors' plea will be that each serves just
one year in prison.
No need to answer - it's a tough call. What I just described to you is the famous
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Prisoner's Dilemma. It involves what is called a Nash equilibrium that is often used to
characterise financial market outcomes. Although Option 4 seems to be a no-brainer,
the Nash equilibrium answer is that both prisoners should betray each other. Think
about it.
So far, I have attempted to characterise how market participants may be interacting with
each other. Let me now turn to how others look at you. The general unsuspecting public
associates you with a certain aura, a certain angle of poise. This brings me to the
theme of my talk.
Financial markets are vital to the functioning of every modern economy. From a
macroeconomic policy perspective, besides the crucial role of price discovery for a host
of financial assets, they enable risk and maturity transformations, incentivise the
efficient allocation of resources, generate returns for capital and bring borrowers and
lenders, and savers and investors together. They also nurture a synaptic continuum
across various market segments that deal in various financial assets. Overarchingly, the
information content in financial markets is priceless for regulators like the Reserve Bank.
For all these reasons and more, monetary policy authorities value financial markets
immensely. They probe them for clues on the future course of the economy. They
weigh how markets second guess their future actions, and the implications thereof.
Most importantly, they employ financial markets to transmit policy impulses from the
short end of the market spectrum to the longer end and from there to the rest of the
economy.
In fact, financial markets produce outcomes which are akin to public goods - they
involve externalities in that they benefit all without incurring any costs; and they are
nonrival in their consumption -- they do not exclude any from their benefits. I would hesitate,
however, to classify any market outcome as a public good for fear of being charged with
heresy. After all, from the time of Markus Tullious Cicero in 43 BC to Adam Smith in
1776 to Milton Friedman in 1963, markets have been upheld as the environs for
competitive self-interest, for Darwinian principles of survival of the fittest. In fact, Milton
Friedman defined the market as the absence of any and all government activity in
economic affairs, or, more broadly still, the absence of the law interfering "with people's
pursuit of happiness." In Friedman's world, the market runs without any state
intervention in response to private demand and supply, driven by the desires and
choices of individuals, companies, and shareholders. Freeing up the market in this way,
according to Friedman, ensures the efficient production and circulation of goods, wealth
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creation, and innovation .
Yet, the experience over several decades has been that markets are prone to
idiosyncratic outcomes, overshoots, and failures. In these circumstances, they need to
be intervened to restore stable functioning and to produce competitive outcomes. This
feature energises the interface of market participants with the policy environment. The
Reserve Bank has a large stake in the efficient functioning of markets, for all the
reasons alluded to earlier. But where should the boundaries be drawn? What is kosher
and what is not? After all, markets too look towards central banks for forward guidance,
for liquidity facilities, for clues on the future course of financial prices like interest rates
and exchange rates.
The special relationship between central banks and financial markets also stems from
the fact that the operational conduct of monetary policy involves buying and selling
assets in financial markets, albeit not motivated narrowly by profit as a market
participant is. From the markets' point of view, the central bank is a specialist participant
whose assignment it is to make the money market. The central bank's standing facilities
to lend and accept deposits are nothing more than the bid-ask spread at which it is
willing to deal in money. This very wide spread establishes the outermost bounds of the
market. Most of the trading in the open market occurs at much narrower spreads.
Absent intervention, we would expect to see the market rate fluctuating within the wide
bounds set by the standing facilities. It is exactly this potential volatility that provides the
incentive for profit-seeking market participants to spring up, offering a narrower bid-ask
spread inside the central bank's spread. It is the balance sheets of these profit-seeking
entities (mainly banks), not the balance sheet of the central bank itself, that provides the
barometer in a modern system. If the central bank announces its interest rate rule -
either explicitly or through its actions and stance - and traders are convinced of its
commitment to follow that rule, then the standing facilities are options that are good not
just until the next intervention or the next meeting of the monetary policy committee
(MPC), but for much longer than that. True, the precise strike price will change over
time, but we know exactly how it will change because the central bank has told us via
its monetary policy stance.
Hence, the relationship between financial markets and the central bank conducting
monetary policy cannot be encapsulated in Nash equilibrium scenarios such as the
prisoner's dilemma. I will suggest that the relationship is one of emotional intimacy in a
dispassionate world, the seeking of mutual comfort in the unknown, a quiet and
meaningful relationship. These are the sentiments used to express the Academy's
appreciation of the 2003 movie which won the Oscar for best screenplay. It was titled
Lost in Translation from which I derive the inspiration for the theme of my talk today.
A popular adage about monetary policy is that it operates with long and variable lags. In
normal times, a rate change takes up to one year for its peak impact on growth and up
to two years for its peak impact on inflation. This is an empirical result validated on high
by Ben Bernanke, Nobel prize winner for economics in 2022, as well as on the earth by
the Reserve Bank's economists in the Report on Currency and Finance, 2021-22.
These lags in transmission pose an existential dilemma for the central bank. For
instance, seeing inflation rising in the future in its forecasts, it raises interest rates. A
few months later, the economy goes through a phase of slowdown. Societal pressures
build up on the central bank to support growth and it gives up on inflation control. Price
pressures persist, get elevated and out of control, eventually killing growth. This is the
classic problem of time inconsistency that haunts all central banks all the time. A
seminal contribution of two economists - Fynn Kydland and Edward Prescott - who
won the Nobel prize in 2004, it has galvanised a worldwide search for proximate
solutions such as appointing a conservative central banker who is more averse to
inflation than the government (Kenneth Rogoff in 1985); writing a state-contingent wage
contract with the head of the central bank, specifying the inflation rate to be achieved
(Carl Walsh in 1995); independence of the central bank; and since the early 1990s,
inflation targeting. You can gauge the lengths to which central banks have to go to be
time consistent in the presence of lags in the operation of monetary policy.
Much of these lags emanates from frictions in financial markets, especially at the
synapses. I will focus on the market segments over which the Reserve Bank exercises
regulatory jurisdiction, namely, the money, government securities, forex and derivatives
markets. Within this focal length, my interest is confined to impediments to monetary
policy transmission that are encountered due to market microstructure as well as the
manner in which each segment integrates into the continuum. My purpose is just to
highlight a few instances of transmission and distribution losses that make my job
adrenaline-driven and pressure-cooked, not to pontificate on any policy agenda.
Money Market
Let me begin with the money market, the happy hunting ground of central banks the
world over. Technically, the responsibility of transmission as far as central banks are
concerned is to ensure that the monetary policy impulse is fully and seamlessly
reflected in the money market. Hence, money market rates, preferably the
uncollateralised rate which provides a sense of the infra-marginal demand for liquidity,
are typically chosen as the operating target of monetary policy. By being the ultimate
supplier of reserves, central banks have a dominant influence on the money market.
In India, the experience has been that the transmission of monetary policy to overnight
money market rates is instantaneous and full. Collateralised markets may quote slightly
finer and draw more volumes than uncollateralised segments, but together they are fully
aligned with the policy stance. Of course, an issue stemming from the thinning of
uncollateralised volumes relates to the integrity, stability and signalling function of the
overnight Mumbai Inter Bank Offer Rate (MIBOR), the benchmark in the largest and
most liquid interest derivative market in India and importantly, a transactions-based rate.
The bulk of money market activity is concentrated in the overnight segment, which has
become the money centre. Consequently, as we proceed outwards on the term curve,
we encounter India's missing markets - the segment between 3 days and three
months. The Reserve Bank has stepped in by removing statutory pre-emptions on
interbank liabilities and by conducting term repos/reverse repos of varying maturities but to
no avail. Vestiges of the cash credit system and unnotified premature withdrawal of
deposits add to these frictions. Undoubtedly, alternatives exist in the form of overnight
indexed swap rates, yields on treasury bills of residual maturity and polled term
MIBORs, but nothing can substitute for a term curve generated from actual transactions.
Another issue in the overnight segment is that of traded deals and reported deals, the
latter involving cooperative banks lending in the later half of the day to scheduled
commercial banks at rates lower than traded rates and artificially pulling down the
aggregation. This drives a wedge between the policy rate and the weighted average call
money rate, which is the operating target.
Thus, even before the monetary policy signal travels through the overnight and term
segments of the money market to the next reference point on the yield curve - the
91day treasury bill (T bill) rate - some part is already lost in transmission.
Primary yields on 91-day T bills are largely influenced by cut-offs, which price in the
policy rate as well as expectations on its future course, as embedded in the stance of
monetary policy. In the secondary market, trading is concentrated in the 91-day T bills,
with the 182-day and 364-day T bills being highly illiquid. Given this discontinuity, the
situation in India calls for active market making in each of them and perhaps issuances
of T bills of other maturities as well so that a continuous risk-free yield curve emerges.
In the commercial paper (CP) segment, which typically prices off the risk-free rate,
issuances are concentrated in maturities of up to three months, with 95 per cent of all
issuances in the highest rating category. CP rates on instruments of more than three
months maturity are highly volatile and unduly influenced by idiosyncratic factors that
may not be in sync with the prevailing monetary policy stance. Furthermore, about 40
per cent of resources mobilised through CPs is by non-banking financial companies or
NBFCs (including housing finance companies or HFCs), which on-lend the funds after
adding margins and premiums, thereby hindering monetary policy transmission. The
certificate of deposit (CD) market has distortions of its own, which I will skip in the
interest of time.
Thus, after the monetary policy action and stance gets seamlessly conveyed to the
overnight market, the transmission progressively loses strength and sometimes
direction as it meanders through the money market spectrum. In recognition of these
impediments, central banks are often persuaded to increase the size of their rate
changes disproportionately in relation to the desired objective to ensure an adequate
amount of transmission, but this can increase borrowing costs inordinately and result in
an overkill of economic activity.
Government securities market
The government securities (G-sec) market is the avenue for raising the budgetary
financing requirements of various levels of government. From a monetary transmission
perspective, however, its importance lies in providing the risk-free term structure for
pricing instruments issued by all other sectors of the economy - this has been referred
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to as a public good . To the extent that participants anticipate policy actions, the yield
curve evolves in a forward-looking manner and this is conducive for monetary policy
transmission. Research in the Reserve Bank in the Indian context suggests that
macroeconomic developments have a significant role in determining the shape of the
yield curve. For instance, an increase in the policy rate has an immediate negative
impact on the slope of the yield curve as the impact of the policy rate change is swiftly
and completely transmitted to short-term maturities, causing the yield curve to become
flatter. Our research found, however, that the level and curvature of the yield curve
need to be watched more closely by monetary policy makers as they have more
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information content on future macroeconomic outcomes than the slope .
The lament of monetary policy in India is that liquidity in the G-sec market is not uniform
across the curve and concentrated in only on-the-run securities of 5 years, 7 years, 10
years and 14 years maturities. Consequently, monetary policy signals are conveyed
across the curve in a disjointed manner, reflecting time-varying liquidity premia, and
with diminishing intensity as maturity increases. The G-sec market is also vulnerable to
spillovers from both global and domestic developments. It can sometimes produce
idiosyncratic results as, for instance, in reaction to the announcement of the
government's borrowing programme or even interest rate changes by systemically
important central banks. Even shifts in international crude prices send them into a
frenzy and as a result, the risk of transmission losses for domestic monetary policy
rises. In the corporate bond market which uses G-sec yields as benchmarks, only
issuers of the highest quality find favour and, as a result, issuers with lower ratings
depend on banks. Transmission to corporates across the entire spectrum of ratings,
therefore, remains incomplete and / or delayed.
The G-sec market's microstructure also tends to dampen transmission. With the holding
pattern of G-secs dominated by "long only" investors with large held-to-maturity
portfolios, a fall out is that liquidity tends to thin out along the curve and there are
instances of short sales morphing into squeezes that can impact money market rates.
There have been occasions during a rising interest rate scenario when 'special' market
repo rates have crashed to near zero, completely out of alignment with the monetary
policy stance and imparting vortexes of volatility that obscure efficient price discovery.
The impact of heterogenous expectations is also evident in the overnight index swap
(OIS) market, which sits at the confluence of money and G-sec markets. Our
experience has been that the OIS market tends to overshoot. Since the OIS curve acts
as the primary instrument for hedging interest rate risk in India, such front-running can
distort transmission and unsettle expectations. Moreover, the OIS market is liquid only
in select tenors and liquidity dries up beyond 5 years. Consequently, hedging of
longterm interest rate risk becomes difficult. This is an important reason why the corporate
bond market is primarily a fixed rate market with tenors limited up to 5 years.
Credit Market
The bank credit market in India accounts for nearly half of the total flow of resources to
the commercial sector of the economy. The practice of changes in deposit rates
preceding changes in lending rates and sticky margins have been prime impediments to
monetary policy transmission. On the one hand, term deposits are typically contracted
at fixed rates. When the policy rate changes, term deposits are re-priced at the margin -
i.e., only in respect of deposits that mature and get renewed. On the other side, the
mandated linking of lending rates for personal loans and micro, small and medium
enterprises (MSMEs) loans directly to external benchmarks which move in sync with the
repo rate is a response to these blockages in the arteries of transmission. In its
aftermath, there has been a rising preference among banks for external
benchmarklinked pricing of loans. This has significantly speeded up transmission and rendered it
complete in several categories of fresh loans. Though the share of fresh loans linked to
marginal cost of funds based lending rates (MCLR) has been declining, nearly half of
outstanding bank credit is still priced off the MCLR, delaying transmission via annual
resets only, and with widely varying spreads. Asset quality, expected loan losses in
credit portfolios and sticky small savings interest rates are additional sources of
variability in spreads, which highlights the significance of financial system soundness
for smoother transmission.
Unlike banks, non-banking financial companies (NBFCs), which have a credit portfolio
equivalent to about one fifth of outstanding bank credit, do not follow any uniform
methodology for pricing their loans. While some NBFCs use their own prime lending
rates as interest rate benchmarks, others use base rates or MCLRs of banks as
external benchmarks. A few do not go by any interest rate benchmark. This
discretionary pricing of spreads undermines monetary policy transmission.
Foreign Exchange Market
The exchange rate is an important channel of monetary policy transmission. Exchange
rate movements influence the inflation and growth outlook as well as financial
conditions for corporates with forex exposures. Our work on exchange rate pass
through (ERPT) or the change in inflation due to a unit change in the exchange rate
shows that there are time-varying threshold effects - a large and unanticipated change
in the exchange rate can cause pass-through to become higher with macroeconomic
consequences, since a third of the CPI consists of imported inflation. Analogously, an
exchange rate depreciation of 5 per cent can benefit exports and squeeze imports,
causing GDP to increase by 15 basis points. Currently, there is increasing evidence that
corporates are experiencing pressures on profit margins due to exchange rate
movements impacting input costs and debt servicing. This has financial stability
implications which necessitates interventions in the forex market to insulate the market
from giant spillovers that crash on our shores when geopolitical hostilities heat up or
when systemic central banks do a '75'.
Forex market developments can influence interest rate transmission in several other
ways. The forward market provides an opportunity to exporters, importers, FIIs,
corporates and banks with external liabilities to hedge their risks, but often forward
premia may not be in alignment with interest rate differentials. Demand supply
mismatches over different tenors, and the associated incentives/disincentives to keep
forex positions open, can impact the decisions of the concerned entities. Offshore
market activity in the Indian rupee (INR) could also amplify INR volatility in the domestic
market, and along with divergent OIS market expectations, it could distort the
transmission of domestic monetary policy.
Conclusion
I realise I have stretched your patience enough. These are not the best times for central
bankers to wax eloquent. From being knights in shining armour during the pandemic,
they have become much maligned and are held responsible for the darkening outlook
globally. The story is told of a man stuck in a traffic jam in the capital of a major
economy. He asks a policeman about what is going on, and is told that the Governor of
the central bank of the country is so depressed about the economy that he wants to
douse himself with gasoline and set himself on fire. So, in sympathy, the crowd has
decided to take out a collection for him. "How much has been collected?" asked the
man. The answer: "40 gallons".
At a time when central bankers seem impervious to the imminent recession and job
losses that loom ahead as they make their rational and cool-headed jumbo rate hikes, a
famous central banker's favourite joke comes to mind. A man needs a heart transplant.
The doctor offers the heart of a five-year old boy. "Too young!" says the man. "How
about the heart of a 40-year old treasury head?" "He doesn't have a heart". Then how
about the heart of a 75-year old central banker?" "I will take it!" "But why?" "It's never
been used!" Yet, perhaps the only subject about which central bankers get emotional
and abandon their rationality is financial markets, the plumbing of the operational
architecture of monetary policy. It is for this reason that the RBI engages not only in
their regulation, but also in their development. Both activities are undertaken with a view
to galvanising monetary policy transmission. Through open market operations, forex
interventions and provision of liquidity, the RBI becomes a market participant for this
purpose. In these situations, sometimes, the RBI may have a view that may differ from
those of other participants. While market participants may have a purely pecuniary
motive, the RBI upholds policy priorities centred around securing and preserving
macroeconomic and financial stability.
In this context, it is worthwhile to pay heed to Governor's recent assurance on liquidity:
"The Reserve Bank remains agile and watchful, continuously monitoring the liquidity
situation and is ready to undertake liquidity operations on either side so that overall
liquidity remains adequate to meet the requirements of the productive sectors of the
economy." Furthermore, on the forex market, Governor provided prescient forward
guidance: "The terminal interest rate that the US Fed is targeting is anybody's guess,
but it cannot be the case that it will tighten monetary policy endlessly. When the
tightening is over, the tide will surely turn. Capital flows to India will resume and external
financing conditions will ease. In this complex world in which both push and pull factors
are at play, the INR, which is market-determined, should be allowed to find its level and
that is what we have been striving to ensure".
In normal times, financial markets and the central bank can each pursue their own risk
management and goal optimisation strategies. In extraordinary times such as now,
when the world is hostage to super tornadoes and no country is immune, it pays for
both to share a common set of expectations. After all, macroeconomic and financial
stability involves shared benefits and for both, high stakes.
Thank you.
1
John Forbes Nash Jr. (June 13, 1928 -May 23, 2015) was an American
mathematician who made fundamental contributions to game theory, geometry, and
partial differential equations. He was awarded the 1994 Nobel Prize in Economics. In
1959, Nash began showing clear signs of mental illness, and spent several years being
treated for schizophrenia. His struggles with his illness became the basis for Sylvia
Nasar's biographical book A Beautiful Mind in 1998, as well as a film of the same name
directed by Ron Howard, in which Nash was portrayed by actor Russell Crowe.
2
Milton Friedman, Capitalism and Freedom, 3rd edition (Chicago: University of
Chicago Press, 2002), 15; Milton Friedman, Free to Choose: A Personal Statement, 3rd
edition (New York: Harcourt, 1990), 20, 145.
3
"Governor's Statement", October 9, 2020
" What is the Yield Curve telling us about the economy " (Patra, John, Kushwaha and
Bhattacharya), RBI Bulletin, June 2022.