Art of Monetary Policy Making: The Indian Context
Speech by Shri Shaktikanta Das, Governor
Reserve Bank of India
Delhi School of Economics (DSE) Diamond Jubilee Distinguished
Lecture; September 5, 2023
I am delighted to be here with all of you to celebrate the Diamond
Jubilee Year of the Delhi School of Economics (DSE). The Delhi School
has made a distinct mark as an institution of excellence and very high
reputation, both in India and abroad. The list of eminent economists and
distinguished alumni associated with the DSE is long and impressive.
The School has inspired generations of students to excel in diverse
streams such as academia, research, government and corporate
sectors. In the Reserve Bank of India, we have also benefitted
immensely from the DSE, with a continuous stream of students joining
the RBI. It is a matter of pride for me to be part of this momentous year
in the history of the institute which has contributed immensely to the
policy discourse in India.
Today, I have chosen to speak on "Art of Monetary Policy
2. Making:
As you
The Indian Context". would be aware, India formally adopted
the flexible inflation targeting (FIT) framework in 2016, in broad
alignment with global trends. The underlying principle of this framework
is that a clearly articulated, legislatively mandated numerical inflation
target is the best foundation for overall macroeconomic stability. Low
and stable inflation helps households and businesses in planning for
long-term savings and investments which ultimately drive innovation,
productivity and sustainable growth. On the contrary, high and volatile
inflation corrodes the economy by denting productivity and the long-
term growth potential. Inflation also imposes disproportionate burden
on the poor.
3. I have structured my talk in the following sequence: (i) evolution
of monetary policy in India, culminating in the adoption of flexible
inflation targeting (FIT) framework; (ii) key elements of this framework,
including the forecasting process; (iii) conduct of monetary policy under
the FIT regime; and (iv) monetary policy challenges at the current
juncture.
Evolution of Monetary Policy Since Independence
4. During the 1950s and 1960s, as the country embarked upon
planned economic development, monetary policy assumed a
developmental role of meeting the credit needs of the economy as
identified under the five-year plans. Bank nationalisation in 1969
ushered in the era of social banking and led to the credit planning phase
(1969-85). This period witnessed widespread use of non-market
instruments such as directed credit, administered interest rates and
moral suasion.
5. Monetary policy during the 1970s and 1980s was constrained by
fiscal dominance, automatic monetisation of budget deficits and
excessive growth of monetary aggregates. The large scale deficit
financing and the resultant high monetary and credit expansion led to
inflationary pressures which were further exacerbated by a series of
shocks, namely, the Indo-Pak war of 1971, the drought of 1973, the
collapse of the Bretton Woods system in 1973, and global oil price
shocks of 1973 and 1979. These events precipitated the adoption of
"monetary targeting with feedback" as a formal monetary policy
framework in 1985. Money supply (M3) became the intermediate target
with the objective of controlling inflation. This approach to monetary
policy was recommended by a Committee led by Prof. Sukhamoy
Chakravarty, a distinguished faculty of Delhi School of Economics.1 In
this framework, the Reserve Bank aimed at controlling the growth in
money supply commensurate with the expected real GDP growth and
a tolerable level of inflation. The cash reserve ratio (CRR) was used as
the primary instrument for monetary control, with both CRR and
statutory liquidity ratio (SLR) reaching their peak levels by 1990 due to
continued fiscal dominance.
6. The deteriorating external balance position in the backdrop of
adverse geo-political developments and domestic macroeconomic
imbalances in the 1980s, and the resultant balance of payments crisis
in 1991, triggered large scale structural reforms, deregulation of the
economy, financial sector liberalisation and a shift towards market
determined exchange rate. In the wake of trade and financial sector
reforms and the consequent rise in foreign capital flows and financial
innovations, the efficacy of broad money as an intermediate target
came under scrutiny around mid-1990s.2 At the same time, there was
a notable shift towards market-based financing for both the government
and the private sector. In this environment, a multiple indicator (MI)
approach was adopted in April 1998 as the new framework of monetary
policy. Under this approach, a host of indicators constituted the
information set used for monetary policy formulation.3 The restrictions
on primary financing (1997),4 enactment of the Fiscal Responsibility
and Budget Management (FRBM) Act in 2003, and the consequent
introduction of fiscal discipline provided enhanced flexibility to monetary
policy. Increased market orientation of the domestic economy and
deregulation of interest rates introduced since the early 1990s also
enabled a shift from direct to indirect instruments of monetary policy.5
The multiple indicator approach remained in vogue from 1998-99 till a
few years after the outbreak of the global financial crisis (GFC) in 2008-
09.6
Introduction of Flexible Inflation Targeting (FIT) in India
7. During the years following the global financial crisis (GFC) in
2008, India witnessed stubbornly high inflation with retail inflation in
India's macroeconomic
double digits and growth losing momentum.
fundamentals appeared fragile with widening twin deficits in both fiscal and
3
These indicators included credit, output, inflation, trade, capital flows, exchange rate, returns
in different markets and fiscal performance, besides monetary aggregates.
4
Primary financing through automatic monetisation of ad hoc treasury bills was done away
with in 1997. Subsequent to the enactment of the FRBM Act, 2003, the Reserve Bank was
finally barred from subscribing to the primary issuances of the government from April 1, 2006.
5
With a view to stabilise short-term interest rates, the Reserve Bank used changes in CRR,
standing facilities and OMOs to affect the quantum of liquidity, while changes in policy rates,
such as the Bank Rate and repo / reverse repo rates under the liquidity adjustment facility
(LAF) were the instruments for changing its price. CRR and SLR are examples of direct
instruments, while LAF operations and OMOs are indirect instruments.
6
Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework,
(Chairman: Dr Urjit R. Patel, 2014).
current accounts and depleting forex reserves. The global ripples created
by the 'taper talk' in May/June 2013 exposed the macroeconomic
India was identified as one among the "fragile
vulnerabilities and five"7.
These events called for an evaluation of the multiple indicator approach.
Accordingly, an Expert Committee was set up in the Reserve Bank to
revise and strengthen the monetary policy framework.8 The Committee
recommended a shift to Flexible Inflation Targeting framework, which
was formally institutionalised with the amendment of the Reserve Bank
of India Act (1934) in May 2016. Incidentally, I was Secretary, Economic
Affairs in the Ministry of Finance at that time dealing with the adoption
of inflation targeting. The amended Act gives a clear mandate to the
Reserve Bank to maintain price stability, keeping in mind the objective
of growth. Price stability has been numerically defined as maintaining a
headline CPI inflation target of 4.0 per cent with a tolerance band of +/-
2 per cent.9 The tolerance band provides flexibility to accommodate
growth and financial stability concerns, supply shocks, and
measurement and forecast errors. The target is set by the Government
of India in consultation with the Reserve Bank for a period of 5 years.10
8. Another major change with the amendment of the Act in 2016 was
the shift from a Governor-centric monetary policy decision making
process to a collegial decision-making body in the form of the Monetary
Policy Committee (MPC).11 The MPC is entrusted with the
responsibility of deciding the policy repo rate with the objective of
achieving the inflation target, keeping in mind the objective of growth. I
am happy to recall that Prof. Pami Dua12 was an esteemed member of
the first MPC and the Reserve Bank benefitted immensely from her
distinguished academic rigour and practical insights. I have personal
experience of the same. The decisions of the MPC are taken by a
majority of votes among the members present. In the event of a tie, the
Governor has a second or casting vote.13 After the conclusion of every
MPC meeting, the RBI publishes the resolution adopted by the MPC. In
addition, Governor's statement and press
briefings are the other modes
of policy communication. The minutes of the individual members of the
MPC are published on the 14th day after the meeting. The RBI is
required to publish a Monetary Policy Report (MPR) once in every six
months, which provides a more detailed review of domestic and global
macroeconomic conditions. These provisions add to transparency of
the whole process.
Forward Looking Monetary Policy and Importance of Forecasting
9. As monetary policy works with long and variable lags, the
forecasts of key macroeconomic variables play a vital role in the
conduct of monetary policy. It is for this reason that inflation targeting
framework is also termed as "inflation forecast targeting" framework.14
To take a real-life analogy, the conduct of monetary policy is like driving
a car on a road with potential ditches and speedbumps. The driver
needs to see them ahead and in time to regulate the speed of his car
and to negotiate the ditch or speedbump smoothly. If the driver reacts
suddenly to a speedbump, he runs the risk of losing control and causing
an accident. Therefore, a successful conduct of monetary policy
depends critically on credible forecasts of key variables like inflation
and growth. In other words, monetary policy has to be forward looking.
Rear view mirror can lead to policy errors.
10. The forecasting process followed at the Reserve Bank has three
broad components, viz. nowcasting, short-term forecasting and
medium-term forecasting.15 The first component of nowcasting uses
high-frequency coincident indicators for the current month or quarter
that are available ahead of the official data releases on inflation and
growth. This is augmented with informed judgement based on
extensive discussions with subject area experts, forward-looking
surveys and market intelligence. The second component comprises
short-term forecasts for up to one-year. These are generated from
semi-structural models that employ time-series and econometric
methods, using aggregate and disaggregated data and information
from forward looking surveys and lead indicators. The third component
involves generating medium-term forecasts and alternate scenarios
using the quarterly projection model (QPM).16 This framework has been
widely accepted and adopted by modern central banks operating under
FIT regime. Its main purpose is to generate medium-term projections
and policy analysis, consistent with achieving the inflation target or
mandate set under the FIT framework. Each of these three components
has different forecasting horizons and hence different approaches.
These forecasts become the backbone of monetary policy making.
Conduct of Monetary Policy under FIT Framework
11.
Let me now turn to the practical side of implementation of the FIT
framework and highlight how we used the flexibility embedded in our
monetary policy framework to judiciously calibrate our actions. In view
of tepid growth outlook for 2019-20, the MPC moved into a rate easing
cycle from February 2019 to stimulate economic activity. During
-
February October 2019, the policy repo rate was reduced by 135 bps
from 6.50 per cent to 5.15 per cent. Also, the stance of policy was
changed from neutral to accommodative in June 2019. Effective
October 1, 2019, the external benchmark-based lending rate (EBLR)
system17 was introduced which quickened the pace of policy
transmission to lending rates.
16
QPM is a forward looking, open economy, calibrated, gap model broadly following a
theoretical framework founded on New Keynesian principles. For a discussion on the QPM in
the Indian context, see John, J, D. Kumar, A. T. George, P. Mitra, M. Kapur and M. D.Patra
(2023), "A Recalibrated Quarterly Projection Model (QPM 2.0) for India", Reserve Bank of
India Bulletin, February, Volume LXXVII(2), pp.59-77
17
Under the EBLR, scheduled commercial banks (excluding regional rural banks and small
finance banks) are required to link all new floating rate personal or retail loans and floating
rate loans to micro small and medium enterprises (MSMEs) to an external benchmark, viz.,
the policy repo rate or 3-month T-bill rate or 6-month T-bill rate or any other benchmark market
interest rate.
12. When the COVID-19 pandemic hit India, the MPC responded
swiftly by reducing the policy repo rate sizeably by 115 bps in a span of
two months (March-May 2020). In parallel, the Reserve Bank infused
large amount of liquidity through both conventional and unconventional
measures to stimulate the economy, restore confidence and revive
market activity, while ensuring that these measures did not engender
Overall, liquidity enhancing measures worth ₹17.2
future fragilities.18
trillion or 8.7 per cent of GDP were announced during the COVID-19
period. All these measures were taken in view of the large output losses
although pandemic-induced supply disruption and demand mismatches
pushed inflation levels higher than 4 per cent. The flexibility embedded
in FIT enabled the MPC to take these measures to safeguard the
economy and the financial sector from the debilitating impact of the
pandemic.
13. In October 2020, the Reserve Bank noted that a stable and
orderly evolution of the yield curve was a public good, the benefit of
which accrues to all stakeholders in the financial system19. Since
monetary policy transmission through the regular interest rate channel
was impeded because of inadequate credit demand during the
18
We undertook measures to augment systemic liquidity through long term repo operations
(LTRO) and sector specific liquidity through targeted long term repo operations (TLTRO) and
refinance facilities. We undertook asset purchases through the G-SAP programme and
operation twist to modulate long term G-sec yields, which, in turn, lowered rates on all
instruments that are priced off the G-sec yield curve.
19
In a market economy, prices of financial instruments like commercial paper and corporate
bonds as well as a part of bank loans are priced off government bond yields/Treasury Bills.
Thus, any undue volatility in the government bond yields will lead to volatility in yields/interest
rates of these financial instruments; moreover, their spreads over government bond yields of
similar maturity can widen due to uncertainty. This can hamper credit and financial flows to
the private sector. Hence, stability in the government bond yields has wider benefits and acts
like a public good, helping the broader real economy.
pandemic, the Reserve Bank activated the asset price channel through
large-scale purchases of government paper through open market
operations (OMOs) and the secondary market government securities
acquisition programme (G-SAP) 20. Large purchases of government
paper softened g-sec yields which, in turn, facilitated the lowering of
yields, i.e., interest rates, on all instruments priced off the yield curve.
14. The pandemic-induced liquidity measures were unique in several
ways: (i) liquidity was provided only through the Reserve Bank's
counterparties for on-lending to stressed entities/sectors; in that sense,
most of it was targeted and not open ended; (ii) asset purchase
programme (G-SAP) was for a limited period of six months and much
smaller in size than advanced economies, and was confined to
government securities in the secondary market; (iii) collateral standards
were not diluted in lending facilities;21 (iv) loan resolution frameworks
for COVID-19 related stressed assets of banks and NBFCs were not
open ended but subject to achievement of certain financial and
operational parameters; and (v) most of the liquidity injection measures
had pre-announced sunset clauses, which helped in an orderly
unwinding of liquidity on their respective terminal dates without de-
anchoring market expectations.
20
With a view to improving monetary policy transmission and enabling a stable and orderly
evolution of the yield curve, the Reserve Bank implemented a secondary market G-sec
acquisition programme (G-SAP) in April-September 2021 to anchor yield expectations in the
context of the large borrowing programme of the Government. The Reserve Bank purchased
amounting to ₹1.2 lakh crore under ₹1.0 lakh crore under
G-secs G-SAP 1.0 and G-SAP 2.0.
21
Unlike in many advanced economies, the collateral standards on the liquidity facilities of
the RBI were not diluted but was confined to central and state government securities only.
Global Upsurge in Inflation and Monetary Tightening Cycle
15. In early 2022, inflation in India was expected to moderate
significantly with a projected average rate of 4.5 per cent for 2022-23.
This was premised upon an anticipated normalisation of supply chains,
the gradual ebbing of COVID-19 infections and a normal monsoon.
Such expectations were, however, belied by the outbreak of hostilities
in Ukraine in February 2022. Initially, the shocks came from food and
fuel prices, which were mainly global in origin, but local factors from
adverse weather events also played an important role in stoking food
inflation. The shocks to inflation got increasingly generalised over the
ensuing months. Under these circumstances, the MPC quickly changed
gears by prioritising inflation ahead of growth in April 2022 and changed
its stance from accommodative to withdrawal of accommodation in
June 2022.
16. In an off-cycle meeting in May 2022, the MPC raised the policy
rate by 40 basis points. This was followed by rate hikes of varying sizes,
in each of the five subsequent meetings till February 2023. In all, the
policy repo rate was raised by 250 bps cumulatively between May 2022
and February 2023. The quantum of rate hikes was calibrated keeping
in view the changing inflation outlook. We have maintained a pause in
the April, June and August 2023 meetings of the MPC as the 250 bps
hike is still working through. Headline inflation had eased to 4.8 per
cent in June 2023 from the peak of 7.8 per cent in April 2022. It,
however, surged to 7.4 per cent in July, mainly on account of a spurt in
vegetable prices which have already started moderating.
17. As I noted in my monetary policy statement on August 10, 2023,
given the likely short-term nature of the vegetable price shocks,
monetary policy can await the dissipation of the first-round effects of
such shocks which may produce short-lived spikes in headline inflation.
We remain on guard to ensure that second order effects in the form of
generalisation and persistence are not allowed to take hold. The
frequent incidences of recurring food price shocks pose a risk to
anchoring of inflation expectations, which has been underway since
September 2022. We will remain watchful of this also. The role of
continued and timely supply side interventions, as being undertaken by
the government, assumes criticality in limiting the severity and duration
of such food price shocks. In these circumstances, it is necessary to be
watchful of any risk to price stability and act timely and appropriately.
We remain firmly focused on aligning inflation to the target of 4.0 per
cent.
Policy Issues and Challenges
18. The current episode of high global inflation and the preceding
overlapping shocks of the pandemic and the Russia-Ukraine war have
raised significant issues and challenges for the conduct of monetary
policy. First, the FIT framework and the target of 4 per cent was put to
test, given the multiple challenges faced by the economy due to the
pandemic. So when the inflation target was to be reviewed in early 2021
and notified for the next 5 years, the Reserve Bank reiterated and
recommended for retention of the 4 per cent target22. It was stressed
that the target and the flexibility built around it had helped us to support
the economy when required and shift gears and re-prioritise inflation
over growth if inflation became high and breached the upper tolerance
level of 6 per cent. In fact, this is precisely what happened when there
was a sudden surge in inflationary pressures following the war in
Ukraine. The pursuit of FIT demonstrated our commitment to price
stability and enhanced the credibility of monetary policy.
19. Second, the level of liquidity in the system plays an important role
in determining the actual overnight call money rate or the weighted
average call money rate (WACR) which is the operating target of
monetary policy. The MPC decides the policy repo rate and the stance
of monetary policy. Thereafter, it is the Reserve Bank's responsibility to
conduct its liquidity management operations in consonance with the
decision of the MPC. During the pandemic, while the MPC reduced the
policy rate by 115 bps within a span of two months, the Reserve Bank
infused significant quantum of liquidity, driving the overnight call money
rates closer to reverse repo rate. This was done to stimulate the
economy, restore confidence and revive market activity in consonance
the MPC's focus
with the accommodative stance of monetary policy. As
shifted to 'withdrawal of accommodation'
in June 2022 in the wake of
surge in inflation, the RBI's liquidity
management operations focused
even more on gradual and calibrated withdrawal of surplus liquidity in a
non-disruptive manner.23 The objective was to reduce the size of the
liquidity surplus in the system to a level consistent with the prevailing
stance of monetary policy. Overall, liquidity management by the
Reserve Bank has been nimble-footed and agile while responding to
evolving circumstances.
20. Third, our experience in recent years shows that supply shocks
have become more frequent with profound implications for inflation
management and anchoring of inflation expectations. A key risk of
sustained high inflation is that it can de-anchor inflation expectations. It
is, therefore, important to remain vigilant and take necessary steps in a
calibrated and timely manner to keep expectations firmly anchored. The
Reserve Bank has been quick and calibrated while navigating through
such turbulences. We look though fleeting shocks but remain prepared
to undertake policy responses if such shocks show signs of persistence
and getting generalised. In such a scenario, monetary policy has to
focus on containing the second round effects.
21. Fourth, price stability and financial stability are complementary to
-
each other. In fact, price stability is an anchor for financial stability but
sometimes, the trade-off between the two becomes a close call as
demonstrated in the recent banking sector turmoil in some advanced
economies. After a near zero policy rate for a prolonged period, central
banks in these economies started raising interest rates aggressively in
2022 which contributed to stress in certain banks in these economies.
In contrast, our battle against inflation is not constrained by financial
stability concerns. In fact, even during the COVID phase, we
continuously took measures to strengthen financial stability. The
Reserve Bank has adopted a prudent approach and taken a number of
initiatives to revamp regulation and supervision of Banks, NBFCs and
other financial entities by developing an integrated and harmonized
architecture. Our banking system remains resilient and healthy with
improved capital ratios, asset quality and profitability.24
22. Fifth, central bank communication plays a vital role in on-ground
efficacy of monetary policy. A few decades ago, central banks believed
that they should be "shrouded in mystery", "say as little as possible" and
"say
cryptically".25 Former Chairman of the Federal Reserve Mr. Alan
remarked
Greenspan had famously "if I seem unduly clear to you, you
must have misunderstood what I said".26 Those times are gone. Now,
managing expectations through effective communication is a vital
instrument in the monetary policy toolkit. In the case of Reserve Bank,
effective forward guidance during the easing cycle reinforced the
impact of our conventional and non-conventional measures during the
pandemic. At the height of the pandemic during 2020 and 2021, the
MPC prioritised growth over inflation. In fact, when inflation was above
the upper tolerance level of 6 per cent in July-August 2020, we provided
both state- and time-based forward guidance of continuing with the
accommodative stance of monetary policy, as output remained well
below its pre-pandemic level. Besides, our forecast also showed that
inflation was likely to soften gradually.27 In the second half of
2020-21, inflation eased in line with our assessment. In the tightening
phase, which commenced in April-May 2022, the scale and nature of
communication has been appropriately fine-tuned and calibrated to
ensure successful transmission of policy rate hikes. The focus has been
on anchoring of inflation expectations by emphasising our firm
commitment to re-align inflation with the target. Overall, central bank
-
communication has to be balanced too much of it may confuse the
market while too little may keep it guessing. We tread a very fine line
and constantly endeavour to refine our communication strategies.
Conclusion
23. Monetary policy framework in India has evolved in line with the
developments in theory and country practices, the changing nature of
the economy and developments in financial markets. Within the broad
objectives, the relative emphasis on inflation, growth and financial
stability has, however, varied across monetary policy regimes since
independence.
24. Our experience during the inflation targeting regime provides
some useful lessons for the conduct of monetary policy. First, being
proactive and nimble footed during a crisis gives one the ability to
respond speedily to fast paced and overwhelming developments.
Second, policy measures should be prudent, targeted and calibrated to
the need of the hour without being tied down by any existing dogma or
- -
orthodoxy. Third, monetary policy actions when needed should be
backed up by appropriate regulatory and supervisory measures,
including macro-prudential instruments, to reinforce the policy impact
and its credibility. Fourth, guidance and confidence need to be provided
to the market and the wider public through effective communication, as
part of the endeavour to anchor expectations and sentiments
appropriately. All these principles were firmly embedded in our actions
during the multiple shocks in the recent period.
25. Alan Blinder, who wore both hats of being an academician and a
practitioner, once said, "Having looked at monetary policy from both
sides now, I can testify that central banking in practice is as much art
as science".28 As students of economics at the prestigious Delhi School
of Economics, I am sure you are well-versed with the science of
monetary policy as a macro-stabilisation tool. I took this opportunity to
throw some light on the art of monetary policy making from a
perspective, especially in a dynamic and uncertain
practitioner's
environment as witnessed in recent years. As we continue our journey
ahead, we remain clear in our focus, flexible in our approach and
strengthen India's macroeconomic
determined in our efforts to
fundamentals and support its growth story.
Thank You. Namaskar.