Deepak Mohanty: Monetary policy framework in India - experience with
multiple-indicators approach
Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the
Conference of the Orissa Economic Association, Baripada, Orissa, 21 February 2010.
* * *
The assistance provided by Shri Binod B. Bhoi is acknowledged.
1. I am honoured to deliver the 2nd Professor Baidyanath Mishra Lecture. Prof. Mishra
is a multi-faceted personality: an economist, an educationist and an institution-builder. Above
all, he is a great teacher who inspired generations of students. I thank the Orissa Economic
Association for giving me this opportunity.
2. I will set out how the framework of monetary policy has evolved over the last two
and half decades. First, I will touch upon the objectives of monetary policy and then discuss
briefly about how monetary framework has evolved globally before dwelling on the Indian
experience. I will conclude with an overall assessment of the monetary policy regime in India.
I. Objectives of monetary policy
3. Central banks derive their objectives from their respective mandates. Monetary
policy could have either a single objective of price stability or multiple objectives besides
price stability. In the literature and in practice, price stability is considered as the dominant
objective of monetary policy.
4. The preamble to the Reserve Bank of India Act, 1934 delineates the basic functions
of the Bank 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". The objectives of monetary policy evolved from this broad
guideline as maintaining price stability and ensuring adequate flow of credit to the productive
sectors of the economy. In practice, monetary policy endeavoured to maintain a judicious
balance between economic growth and price stability.
5. The question is how do we define price stability? Price stability does not mean zero
inflation. It is considered as a low and stable order of inflation. This is because both high
inflation and deflation impose costs on the economy by way of loss of output and
misallocation of resources. For advanced economies, an inflation rate of about 2 per cent is
equated with price stability. For an emerging market economy (EME) like India, going
through significant structural changes, a slightly higher rate of inflation which allows relative
prices to adjust smoothly can be considered appropriate. The Chakravarty Committee (1985)
had defined an inflation rate of 4 per cent per annum as tolerable for India.
6. India is a moderate inflation country with the long-term average inflation rate
remaining in a single digit of about 7.5 per cent since 1970-71. Over this 40-year period, the
average inflation rate, however, has decelerated to about 5.5 per cent in the decade of
2000s. The medium term objective of monetary policy is to bring down the average inflation
rate to around 3.0 per cent consistent with India's integration with the global economy.1
7. While a low level of inflation is essential to sustain high levels of growth, it is not
sufficient to maintain financial stability, as has been demonstrated by the recent global
financial crisis. Consequently, besides price stability, ensuring orderly conditions in the
financial markets has become a key policy concern. In this context, it may be indicated that
financial stability had emerged as another important objective of monetary policy in India
much before the crisis. Thus, monetary policy in India has evolved to have multiple
objectives of price stability, financial stability and growth. These objectives are not inherently
contradictory, rather mutually reinforcing. Price and financial stability are important for
sustaining high levels of growth which is the ultimate objective of public policy.
II. Evolution of monetary policy framework
8. In order to attain the objectives of policy it is necessary to have a consistent policy
framework. At a theoretical level, the evolution of monetary framework could be traced to the
desire to reduce inflationary bias in the economy through various refinements under the
broader debate on "rules" versus "discretion" in policy making, and more recently,
"constrained discretion" which believes that the doctrines of "rules" and "discretion" are not
mutually exclusive2. In practice, the nature of the framework is contingent upon two important
considerations. First, the level of development of financial markets and institutions; and
second, the degree of openness of the economy to trade and capital flows. In India, like most
other countries, the monetary policy framework has evolved in response to and in
consequence of financial developments and shifts in the underlying transmission
mechanism.
How did monetary policy framework evolve globally?
9. In order to achieve the objectives of monetary policy which are not under the direct
control of central banks, monetary authorities typically set "intermediate targets", which bear
a stable relationship with the overall objectives of monetary policy3. The selection of
intermediate target is also conditional upon the channels of monetary transmission - the
process through which monetary policy actions impact the ultimate objectives. Historically,
although credit targets were prevalent, the concept of a formal intermediate target emerged
with the monetarist emphasis on money targeting in an environment of worsening inflation in
the 1970s and observed stable relationship among money, output and prices. A number of
major central banks such as Switzerland, Germany, Japan, the UK, the USA, France,
Australia and Canada adopted monetary targets in the mid-1970s. In the 1980s, financial
market innovations reduced the need for financial intermediation by the banking system and
in turn began to impart volatility to the behaviour of monetary aggregates. The consequent
weakening of the stable relationship among money, output and prices made many advanced
country central banks to move towards signaling monetary policy stance through setting of
interest rates. Monetary targeting, however, continued in some form in many bank-based
economies in continental Europe such as Germany, France and Switzerland where it was
possible to establish money demand stability with redefinition of monetary aggregates.
10. Given the under-developed nature of financial markets coupled with the
quantitybased credit channel of monetary transmission, money target was considered suitable in
case of developing countries. In the 1980s, monetary targeting was adopted in many
developing countries such as Brazil, China, Indonesia, Korea, Malaysia, Peru, Philippines,
Russia and Venezuela. As financial innovations spread to developing countries and they
became more open to external capital flows, monetary targeting proved less effective.
11. The weakening of monetary targeting framework, both in advanced and developing
countries, triggered a search for alternate monetary frameworks. As it was also widely
recognised that monetary policy can contribute to sustainable growth by maintaining price
stability, beginning with New Zealand in 1989, a number of advanced and developing
countries moved to "inflation targeting". Under this approach, central banks target the final
objective, i.e., inflation itself rather than targeting any intermediate variable. Among the major
central banks, the Bank of England (BoE) formally adopted inflation targeting in 1992.
12. The US Federal Reserve (Fed) follows a more eclectic approach, which can be
termed as risk management approach, in pursuit of its twin objectives of price stability and
maximum employment. Under the risk management approach, the Fed takes a policy view
on interest rate on consideration of balance of risks to inflation and growth. Although the
European Central Bank (ECB) has a single mandate of price stability, it is not an inflation
targeting central bank. Its policy decisions are based on a "two pillars" strategy comprising of
"economic analysis" and "monetary analysis". Money supply continues to be an important
variable in its analytical tool under the second pillar reflecting the enduring influence of the
German Bundesbank which was a major monetary targeting central bank. Notwithstanding
the difference in approach among central banks, price stability is accepted as the
predominant objective of monetary policy.
How did monetary policy framework evolve in India?
13. In India also, monetary policy framework has undergone significant transformation
over time. In the 1960s, as inflation was considered to be structural and inflation volatility was
mainly caused by agricultural failures, there was greater reliance on selective credit controls.
The aim was to regulate bank advances to sensitive commodities to influence production
outlays, on the one hand and to limit possibilities of speculation, on the other. In the 1970s,
there was a surge in inflation on account of monetary expansion induced by expansionary
fiscal policies besides the oil price shocks. By the early 1980s, there was a broad agreement
on the primary causes of inflation. It was argued that while fluctuations in agricultural prices
and oil price shocks did affect prices, sustained inflation since the early 1960s could not have
occurred unless it was supported by the continuous excessive monetary expansion
generated by the large-scale monetisation of the fiscal deficit4.
14. Against the backdrop, the Committee to Review the Working of the Monetary
System (Chairman: Prof. Sukhamoy Chakravarty; 1985), set up by the Reserve Bank,
recommended a monetary targeting framework to target an acceptable order of inflation in
line with desired output growth. It also recommended for limiting monetary expansion through
the process of monetisation of fiscal deficit by an agreement between the Reserve Bank and
the Government.5 With empirical evidence supporting reasonable stability in the demand
function for money, broad money (M3) formally emerged as an intermediate target. Under this
approach, a monetary projection is made consistent with the expected real GDP growth and
a tolerable level of inflation6. The framework was, however, a flexible one allowing for various
feedback effects. Moreover, money supply target was relatively well understood by the public
at large.7
15. With the pace of trade and financial liberalization gaining momentum following the
initiation of structural reforms in the early 1990s, the efficacy of broad money as an
intermediate target of monetary policy came under question. The Reserve Bank's Monetary
and Credit Policy for the First Half of 1998-99 observed that financial innovations emerging
in the economy provided some evidence that the dominant effect on the demand for money
in the near future need not necessarily be real income, as in the past.
16. Since the mid-1990s, apart from dealing with the usual supply shocks, monetary
policy had to increasingly contend with external shocks emanating from swings in capital
flows, volatility in the exchange rate and global business cycles. Subsequently, increase in
liquidity emanating from capital inflows raised the ratio of net foreign assets (NFA) to
Reserve Money (Chart 1). This rendered the control of monetary aggregates more difficult.
Consequently, there was also increasing evidence of changes in the underlying transmission
mechanism of monetary policy with interest rate and the exchange rate gaining importance
vis-à-vis quantity variables.8 Bank credit to private sector as a per cent of GDP also started
rising, though it still remains low as compared to advanced economies and many EMEs
underscoring the potential for greater credit penetration (Table 1). These developments
necessitated refinements in the conduct of monetary policy.
17. Against this backdrop, the Reserve Bank formally adopted a "multiple indicators
approach" in April 1998 with a greater emphasis on rate channels for monetary policy
formulation. As a part of this approach, information content from a host of quantity variables
such as money, credit, output, trade, capital flows and fiscal position as well as from rate
variables such as rates of return in different markets, inflation rate and exchange rate are
analyzed for drawing monetary policy perspectives. The multiple-indicators approach, as
conceptualised when Dr. Bimal Jalan was the Governor, continued to evolve and was
augmented by forward looking indicators and a panel of parsimonious time series models.
The forward looking indicators are drawn from the Reserve Bank's industrial outlook survey,
capacity utilization survey, professional forecasters' survey and inflation expectations
survey9. The assessment from these indicators and models feed into the projection of growth
and inflation. Simultaneously, the Reserve Bank also gives the projection for broad money
which serves as an important information variable, so as to make the resource balance
(M3),
in the economy consistent with the credit needs of the government and the private sector.
Thus, the current framework of monetary policy can be termed as an augmented multiple
indicators approach as illustrated below (Exhibit 1).
18. This large panel of indicators is at times criticised as a "check list" approach, as it
does not provide for a clearly defined nominal anchor for monetary policy. However, given
the level of financial market development, the evolving nature of monetary transmission and
the need to maintain the resource balance between the government and the private sector,
monetary policy assessment becomes inherently complex.
19. Globally, it is now recognised that the task of monetary management has become
more challenging. In view of central banks operating in an environment of high uncertainty
regarding the functioning of the economy as well as its prevailing state and future
developments, a single model or a limited set of indicators may not be a sufficient guide for
monetary policy. Instead, an encompassing and integrated set of data is required. This
reinforces the usefulness of monitoring a number of macroeconomic indicators in the conduct
of monetary policy. In the context of the recent crisis, it is argued that monitoring money and
credit may help policymakers interpret asset market developments and draw implications
from them for the economic and financial outlook.10 There is a need to raise awareness in
the central banking community of the importance of monetary analysis and its implications,
both for economies individually and globally.11 Thus, there is now increasing support for a
broad-based approach to monetary policy.
III. Experience with monetary framework in India
Experience with monetary targeting approach
20. An earlier paper12 examined the experience with the monetary targeting approach.
Despite the adoption of formal monetary targeting, no specific money targets were set during
the period 1985-90 except for fixing a ceiling linked to average growth of broad money (M3)
in previous year(s). This was because there continued to be large overhang of excess
liquidity due to primary money creation. The biggest impediment to explicit monetary
targeting was the fact that the Reserve Bank had no controls over its credit to the central
government, which accounted for the bulk of the creation of reserve money. The Reserve
Bank could at best set limits on the secondary expansion of money through instruments such
as cash reserve ratio (CRR), statutory liquidity ratio (SLR) and selective credit controls. As a
result, CRR reached its prescribed ceiling of 15 per cent of net demand and time liabilities
(NDTL) of banks in July 1989 and the SLR reached the peak of 38.5 per cent in September
1990. Despite these measures, however, money supply growth remained high, which
contributed to inflation. The setting of monetary targets and actual achievements during the
monetary targeting period is presented below in Table 2.
Experience with multiple indicators approach
21. The process of financial liberalization and deregulation of interest rates introduced
since the early 1990s enhanced the role of market forces in the determination of interest
rates and the exchange rate. Accordingly, the Reserve Bank placed greater emphasis on the
money market as the focal point for the conduct of monetary policy and for fostering its
integration with other market segments. Following the Narsimham Committee (1998)
recommendations, the Reserve Bank introduced the liquidity adjustment facility (LAF) in June
2000 to manage market liquidity on a daily basis and also to transmit interest rate signals to
the market. Collateralized borrowing and lending operations (CBLO) was introduced as a
new money market instrument in January 2003. The call money market was transformed into
a pure inter-bank market by August 2005 in a phased manner.
22. As a result, the money market developed significantly over the years as reflected in
increased turnover in various market segments (Table 3). Along with developing money
markets, the Reserve Bank has also undertaken various measures to develop the
government securities and foreign exchange market, increasing the depth of the financial
markets (Chart 2).
23. All these reforms have also led to improvements in liquidity management operations
by the Reserve Bank as reflected in general containment of call rates within the LAF corridor
except occasional volatility. Apart from imparting stability in call money rates, this has also
resulted in greater market integration as reflected in close co-movement of rates in various
segments of the money market (Chart 3). The rule-based fiscal policy pursued under the
Financial Responsibility and Budget Management (FRBM) Act, by easing fiscal dominance,
contributed to overall improvement in monetary management.
24. During the recent period, the issue of managing large and persistent capital inflows
in excess of the absorptive capacity of the economy added another dimension to the liquidity
management operations. Initially, the liquidity impact of large capital inflows were sterilised
through open market operation (OMO) sales and LAF operations. Given the finite stock of
government securities in the Reserve Bank's portfolio and the legal restrictions on issuance
of its own paper, additional instruments other than LAF were needed to contain liquidity of a
more enduring nature. This led to the introduction of the market stabilisation scheme (MSS)
in April 2004. Under this scheme, short term government securities were issued but the
amount remained impounded in the Reserve Bank's balance sheet for sterilisation purposes.
Interestingly, in the face of reversal of capital flows during the recent crisis, unwinding of
such sterilised liquidity under the MSS helped to ease liquidity conditions (Chart 4).
25. The efficient conduct of monetary policy is judged ultimately in terms of its ability to
stabilise real economic activity and inflation and also ensuring financial stability consistent
with the policy objectives. An assessment of the multiple indicators approach for the period
1998-99 to 2008-09 reveals that actual outcome of GDP growth has been generally higher
than the projections indicated in the monetary policy statements, while it has generally been
lower in case of inflation (Table 4).
IV. Overall assessment
26. The monetary policy framework in India has undergone significant shifts from a
monetary targeting regime to a multiple indicators regime. Such a transition was conditioned
by the developments of financial markets, increasing integration of the Indian economy with
the global economy and changing transmission of monetary policy. The multiple indicators
approach, conceptualized in 1998, has since been augmented by forward looking indicators
from surveys and a panel of time series models. Moreover, the multiple indicators approach
continues to evolve. Though the multiple indicators approach is subject to criticism for the
absence of a clearly defined anchor, in the wake of the recent global financial crisis there is
recognition of the usefulness of a broad indicators-based assessment of monetary policy.
27. On the basis of the above assessment, I will give a comparison of the relative
performance of the monetary regimes in terms of key macroeconomic variables over three
periods: (i) the decade preceding the monetary targeting period (1976-85); (ii) monetary
targeting period (1986-98) and (iii) multiple indicators period so far (1999-2009) (Table 5).
28. From this overall assessment, the following broad conclusions can be drawn.

First, real GDP growth, on an average, has improved successively from 4.6 per cent
in the decade prior to the monetary targeting period to 5.5 per cent in the monetary
targeting period and further to 7.1 per cent in the multiple indicators period. Not only
growth has improved but it has become more stable under the multiple indicators
approach.

Second, headline WPI inflation, on an average, increased during the monetary
targeting regime alongside significant increase in fiscal deficit, although there was a
reduction in volatility in inflation13. Under the multiple indicators approach, both WPI
and CPI inflation fell significantly. The fall in inflation was accompanied by
substantial reduction in fiscal deficit. This underscores the importance of fiscal
consolidation to sustain higher levels of growth with price stability.

Third, while the volatility of WPI inflation reduced during the multiple indicators
period, it increased for CPI inflation reflecting higher volatility in food prices. This
underlines the importance of supply management and a greater focus on agricultural
development to contain food price inflation.

Fourth, money supply (M3) growth declined over the regimes though volatility of M3
increased slightly during the multiple indicators regime reflecting emerging
importance of interest rate in monetary transmission. The shift in operating objective
to stabilise overnight interest rate so that it transmits through the term structure is
reflected in a discernible reduction in the overnight interest rate with lower volatility.

Fifth, exchange rate, on an average, has depreciated successively both in nominal
and real terms. However, it has become more stable during the multiple indicators
approach than the monetary targeting regime. This could be partly attributed to
accumulation of reserves and management of exchange rate to contain volatility.
 Sixth, the improved performance of monetary policy was facilitated by supportive
fiscal policy - discontinuation of the practice of automatic monetisation and
rulebased deficit reduction programme under the Fiscal Responsibility and Budget
Management (FRBM) Act - which enhanced instrument independence of the
Reserve Bank.
 Finally, the recent overall improvement in macroeconomic performance cannot be
ascribed to monetary policy alone. Apart from a rule-based fiscal policy, productivity
enhancing structural reforms, sharp increase in saving and investment, increasing
integration with the global economy, a low global inflation environment and the
unleashing of the entrepreneurial spirit of the private sector played an important role.