Shaktikanta Das: Seven ages of India's monetary policy
Address by Mr Shaktikanta Das, Governor of the Reserve Bank of India, at the St. Stephen's
College, University of Delhi, Delhi, 24 January 2020.
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I am delighted to be back in my alma mater. Being here, brings back a surge of memories.
Today, I wish to dwell upon a few aspects of central banking in the Indian context and RBI's role
in the current situation. I shall specifically focus on the evolution of monetary policy regimes in
India and if I am to use the poetic license of Shakespeare, may I call it the seven ages of India's
monetary policy?
2. The history of central banking goes back to the seventeenth century when the first institution,
'the Riksbank', recognised as a central bank was set up in Sweden in 1668. Set up as a joint
stock bank, it was chartered to lend funds to the government funds and to act as a clearing
house for commerce. Later on, the Riksbank abandoned commercial lending and was granted
a monopoly for issuing banknotes in 1897. Subsequently, several countries set up institutions
that functioned as central banks. These early central banks like the Bank of England and
Banque de France, though set up with private capital, helped sovereigns finance their debt and
were engaged in banking activities. Since then, the role of central banks across countries has
constantly evolved in line with the changing needs of their economies and evolving financial
structure. Today, the functions of modern central banks are vastly different from what was
expected from their early counterparts.
3. Let me briefly outline how the profile of the Reserve Bank has been intrinsically interwoven
with the economic and financial developments in our country since independence.
4. The Reserve Bank was set up under the Reserve Bank of India Act 1934 with the original
Preamble that describes the broad mandate of the Reserve Bank as follows:
"it is expedient to constitute a Reserve Bank for India 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".
5. Later, the Reserve Bank of India was nationalised in 1949. While the Reserve Bank
continues to perform its traditional functions such as currency management, bankers' bank and
banker to the Government, its function of conducting monetary policy has undergone a sea
change in various respects from time to time.
6. As we know, policy change is generally guided by two major forces: first, the objectives that
may seem appropriate earlier may lose relevance with changing behavioural relationships over
time. For instance, when we found that the relationship of money with nominal income was not
very predictable as in the past, we adopted multiple indicators approach in 1998. Second, the
state of knowledge, updated with new theories and evidences, requires to be applied in pursuit
of better policy outcomes. This is precisely what shaped the conduct of monetary policy in India
over time.
Evolution of monetary policy in line with the changing character of the economy
1935 to 1949: Initial Phase
7. It is interesting to note that the Reserve Bank came into being in the backdrop of the great
depression facing the world economy. Given the unsettled international monetary systems, the
Preamble to the RBI Act, 1934 provided the edifice for the evolution of monetary policy
framework. Until independence, the focus was on maintaining the sterling parity by regulating
liquidity through open market operations (OMOs), with additional monetary tools of bank rate
and cash reserve ratio (CRR). In other words, exchange rate was the nominal anchor for
monetary policy. In view of the agrarian nature of the economy, inflation often emerged as a
concern due to frequent supply side shocks. While the price control measures and rationing of
essential commodities was undertaken by the Government, the Reserve Bank also used
selective credit control and moral suasion to restrain banks from extending credit for
speculative purposes.
1949 to 1969: Monetary Policy in sync with the Five-Year Plans
8. India's independence in 1947 was a turning point in the economic history of the country.
What followed was a policy of planned economic development. These two decades were
characterised not only by a predominant role of the state but also by a marked shift in the
conduct of monetary policy. The broad objective was to ensure a socialistic pattern of society
through economic growth with a focus on self-reliance. This was intended to be achieved by
building up of indigenous capacity, encouraging small as well as large-scale industries,
reducing income inequalities, ensuring balanced regional development, and preventing
concentration of economic power. Accordingly, the government also assumed entrepreneurial
role to develop the industrial sector by establishing public sector undertakings.
9. As planned expenditure was accorded pivotal role in the process of development, there was
emphasis on credit allocation to productive sectors. The role of monetary policy, therefore,
during this phase of planned economic development revolved around the requirements of
fiveyear plans. Even if there was no formal framework, monetary policy was relied upon for
administering the supply of and demand for credit in the economy. The policy instruments used
in regulating the credit availability were bank rate, reserve requirements and open market
operations (OMOs). With the enactment of the Banking Regulation Act in 1949, statutory
liquidity ratio (SLR) requirement prescribed for banks emerged as a secured source for
government borrowings and also served as an additional instrument of monetary and liquidity
management. Inflation remained moderate in the post-independence period but emerged as a
concern during 1964-68.
1969 to 1985: Credit Planning
10. Nationalisation of major banks in 1969 marked another phase in the evolution of monetary
policy. The main objective of nationalisation of banks was to ensure credit availability to a wider
range of people and activities. As banks got power to expand credit, the Reserve Bank faced
the challenge of maintaining a balance between financing economic growth and ensuring price
stability in the wake of the sharp rise in money supply emanating from credit expansion.
Besides, Indo-Pak war in 1971, drought in 1973, global oil price shocks in 1973 and 1979, and
collapse of the Bretton-woods system in 1973 also had inflationary consequences. Therefore,
concerns of high inflation caused by deficit financing during 1960s gathered momentum during
the 1970s. Incidentally, the high inflation in the domestic economy coincided with stagflation -
high inflation and slow growth - in advanced economies. In such a milieu, traditional monetary
policy instruments, viz., the Bank Rate and OMOs were found inadequate to address the
implications of money supply for price stability. As banks were flushed with deposits under the
impact of deficit financing, they did not need to approach RBI for funds. This undermined the
efficacy of Bank Rate as a monetary policy instrument. Similarly, due to underdeveloped
government securities market, OMOs had limited scope to be used as monetary policy
instrument. During this phase, the average growth rate hovered around 4.0 per cent, while
wholesale price index (WPI) based inflation was around 8.8 per cent.
1985 to 1998: Monetary Targeting
11. In the 1980s, fiscal dominance accentuated as reflected in automatic monetisation of
budget deficit through ad hoc treasury bills and progressive increase in SLR by 1985.
Concomitantly, inflationary impact of deficit financing warranted tightening of monetary policy -
both the CRR and Bank Rate were raised significantly. The experience of monetary policy in
dealing with the objectives of containing inflation and promoting growth eventually led to
adoption of monetary targeting as a formal monetary policy framework in 1985 on the
recommendations of the Chakravarty Committee. In this framework, with the objective of
controlling inflation through limiting monetary expansion, reserve money was used as operating
target and broad money as intermediate target. The targeted growth in money supply was
based on expected real GDP growth and a tolerable level of inflation. This approach was flexible
as it allowed for feedback effects. CRR was used as the primary instrument for monetary
control. Nonetheless, due to continued fiscal dominance, both SLR and CRR reached their
peak levels by 1990.
12. The worsening of fiscal situation in late 1980s was manifested in deterioration of external
balance position and collapse in domestic growth in 1991-92, in the backdrop of adverse global
shocks - the gulf war and disintegration of the Soviet Union. The resultant balance of payments
crisis triggered large scale structural reforms, financial sector liberalization and opening up of
the economy to achieve sustainable growth with price stability. Concurrently, there was a shift
from fixed exchange rate regime to a market determined exchange rate system in 1993. In the
wake of trade and financial sector reforms and the consequent rise in foreign capital flows and
financial innovations, the assumption of stability in money demand function as well as efficacy
of broad money as intermediate target came under question. At the same time, there was a
notable shift towards market-based financing for both the government and the private sector. In
fact, automatic monetisation through ad hoc treasury bills was abolished in 1997 and replaced
with a system of ways and means advances (WMAs). During this period, average domestic
growth rate was 5.6 per cent and average WPI-based inflation was 8.1 per cent.
1998 to 2015: Multiple Indicators Approach
13. As liberalisation of the economy since the early 1990s and financial innovations began to
undermine the efficacy of the prevalent monetary targeting framework, a need was felt to review
the monetary policy framework and recast its operating procedures. As a result, the Reserve
Bank of India adopted multiple indicators approach in April 1998. Under this approach, besides
monetary aggregates, a host of forward looking indicators such as credit, output, inflation,
trade, capital flows, exchange rate, returns in different markets and fiscal performance
constituted the basis of information set used for monetary policy formulation. The enactment of
the Fiscal Responsibility and Budget Management (FRBM) Act in 2003, by introducing fiscal
discipline, provided 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. There was, therefore, greater
emphasis on rate channels relative to quantity instruments for monetary policy formulation.
Accordingly, short-term interest rates became instruments to signal monetary policy stance of
RBI.
14. In order to stabilise short-term interest rates, the Reserve Bank placed greater emphasis on
the integration of money market with other market segments. It modulated market liquidity to
steer monetary conditions to the desired trajectory by using a mix of policy instruments. Some
of these instruments including changes in reserve requirements, standing facilities and OMOs
were meant to affect the quantum of marginal liquidity, while changes in policy rates, such as
the Bank Rate and reverse repo/repo rates were the instruments for changing the price of
liquidity.
15. An assessment of macroeconomic outcomes suggests that the multiple indicator approach
served fairly well from 1998-99 to 2008-09. During this period, average domestic growth rate
improved to 6.4 per cent and WPI based inflation moderated to 5.4 per cent.
2013-2016: Preconditions Set for Inflation Targeting
16. In the post-global financial crisis period (i.e., post-2008), however, the credibility of this
framework came into question as persistently high inflation and weakening growth began to
coexist. In the face of double-digit inflation of 2012-13, the US Fed's taper talk in May/June 2013
posed significant challenges to domestic monetary policy for maintaining the delicate balance
between sustaining growth, containing inflation and securing financial stability. The extant
multiple indicators approach was criticised on the ground that a large set of indicators do not
provide a clearly defined nominal anchor for monetary policy. An Expert Committee was set up
by RBI to revise and strengthen the monetary policy framework and suggest ways to make it
more transparent and predictable. In its Report of 2014, the Committee reviewed the multiple
indicators approach and recommended that inflation should be the nominal anchor for the
monetary policy framework in India. Against this backdrop, the Reserve Bank imposed on itself
a glide path for bringing down inflation in a sequential manner - from its peak of 11.5 per cent in
November 2013 to 8 per cent by January 2015; 6 per cent by January 2016 and 5 per cent by
Q4 of 2016-17.
2016 onwards: Flexible Inflation Targeting
17. Amid this, a Monetary Policy Framework Agreement (MPFA) was signed between the
Government of India and the Reserve Bank on February 20, 2015. Subsequently, flexible
inflation targeting (FIT) was formally adopted with the amendment of the RBI Act in May 2016.
The role of the Reserve Bank in the area of monetary policy has been restated in the amended
Act as follows:
"the primary objective of monetary policy is to maintain price stability while keeping
in mind the objective of growth".
18. Empowered by this mandate, the RBI adopted a flexible inflation targeting (FIT) framework
under which primacy is accorded to the objective of price stability, defined numerically by a
target of 4 per cent for consumer price headline inflation with a tolerance band of +/- 2 per cent
around it, while simultaneously focusing on growth when inflation is under control. The relative
emphasis on inflation and growth depends on the macroeconomic scenario, inflation and
growth outlook, and signals emerging from incoming data. Since then RBI has been conducting
monetary policy in a forward-looking manner and effectively communicating its decisions to
maintain inflation around its target and thereby to support growth. At the same time, RBI is also
fine-tuning its operating procedures of monetary policy for effective policy transmission across
the financial markets and thereby onto the real economy. As an outcome, inflation has fallen
successively and has averaged below 4 per cent since 2017-18, notwithstanding recent up-tick
in inflation driven by food prices, especially the sharp increase in vegetable prices reflecting the
adverse impact of unseasonal rains and cyclone.
Evolution of monetary policy in line with the changing Theoretical Developments and
International Best Practices
19. The monetary policy framework in India has also been guided by developments in theory
and international best practices. For instance, the collapse of the Bretton-Woods system of
fixed exchange rates and high inflation in many advanced economies during the 1970s provided
the necessary background to the choice of money supply as a nominal anchor. Since the late
1980s, however, experience of many advanced countries with monetary targeting framework
was not satisfactory inter alia due to growing disconnect between monetary aggregates and
goal variables such as inflation. A similar instability in money demand function was also
evidenced in the Indian context in the 1990s which led to a shift from monetary targeting to
multiple indicators approach in 1998.
20. Since early 1990s, beginning with New Zealand in 1990, many advanced and emerging
market economies (EMEs) have switched to inflation targeting as the preferred policy
framework. India, however, formally adopted the framework in 2016 which has helped us in
terms of learning from the experiences of a diverse set of countries over a long period of time.
In fact, the post-global financial crisis experience questioned the relevance of narrow focus on
price stability as the sole objective of monetary policy, which called for adoption of a flexible
approach to inflation targeting to achieve macro-financial stability. In this milieu, financial
stability has emerged as another key consideration for monetary policy, though jury is still out
as to whether it should be added as an explicit objective. It is interesting to note that the central
banking function as the lender of last resort (LOLR) has remained intact, notwithstanding the
developments and refinements in the policy frameworks across countries, including India.
Evolution of monetary policy in line with the financial market developments
21. Financial markets play a critical role in effective transmission of monetary policy impulses
to the rest of the economy. Monetary policy transmission involves two stages. In the first stage,
monetary policy changes are transmitted through the money market to other markets, i.e., the
bond market and the bank loan market. The second stage involves the propagation of monetary
policy impulses from the financial market to the real economy - by influencing spending
decisions of individuals and firms. Within the financial system, money market is central to
monetary operations conducted by the central bank.
22. In the case of India, money market prior to the 1980s was characterised by paucity of
instruments and lack of depth. Owing to limited participation, money market liquidity was highly
skewed, characterised by a few dominant lenders and a large number of chronic borrowers. In
the presence of ad hoc Treasury Bills with fixed interest rate under the system of automatic
monetisation, Treasury Bills could not emerge as a short-term money market instrument.
Administered interest rates and captive investor base in government securities market further
impeded open market operations as an ineffective instrument of monetary control. The
prevalence of interest rate regulations along with restrictions on participation prohibited the
integration of different market segments which is a prerequisite for effective monetary policy
transmission. In this environment, monetary policy initially relied mainly on credit planning and
selective credit controls and eventually on monetary targeting through quantitative instruments.
23. Financial markets reforms since the early 1990s, therefore, focused on dismantling various
price and non-price controls in the financial system to facilitate integration of financial markets.
Reform measures encompassed removing structural bottlenecks, introducing new
players/instruments, ensuring free pricing of financial assets, relaxing quantitative restrictions,
strengthening institutions, improving trading, clearing and settlement practices, encouraging
good market practices and promoting greater transparency. These reforms gradually facilitated
the price discovery in financial markets and interest rate emerged as a signaling mechanism.
This paved way for introduction of the Liquidity Adjustment Facility (LAF) in 2000-01 as a tool
for both liquidity management and also a signalling device for interest rates in the overnight
money market. Amid greater integration of domestic financial markets with global markets,
subsequently, the RBI also began to recognise the impact of global developments on domestic
monetary policy. The developments in financial markets enabled the Reserve Bank to use
market-based instruments of monetary policy and utilise the forward-looking information
provided by financial markets in the conduct of monetary policy under the multiple indicators
approach.
24. Although various segments of financial markets had acquired depth and maturity over time,
a key challenge has been on fuller and faster transmission of policy rate changes not only to
money market segments but also to the broader credit markets. In order to address these
challenges, the Reserve Bank has been trying different models. At the same time, the liquidity
management framework was also fine-tuned since April 2016 with the objective of maintaining
the operating target close to the policy rate. Under this framework, the Reserve Bank assured
the market to meet its durable liquidity requirements while fine-tuning its operations to make
short-term liquidity conditions consistent with the stated policy stance. This was achieved
through a variety of instruments including fixed and variable rate repo/reverse repo of various
maturities, the marginal standing facility (MSF) and outright open market operations -
complemented at times by the cash management bills and foreign exchange swaps.
Challenges in the Current Context
25. One of the major challenges for central banks is the assessment of the current economic
situation. As we all know, the precise estimation of key parameters such as potential output and
output gaps on a real time basis is a challenging task, although they are crucial for the conduct
of monetary policy. In recent times, shifting trend growth in several economies, global spillover
effects and disconnect between the financial cycles and business cycles in the face of supply
shocks broadly explain why monetary policy around the world is in a state of flux. Nonetheless,
a view has to be taken on the true nature of the slack in demand and supply-side shocks to
inflation for timely use of counter cyclical policies.
26. We, in the Reserve Bank, therefore, constantly update our assessment of the economy
based on incoming data and survey based forward looking information juxtaposed with
modelbased estimates for policy formulation. This approach helped the Reserve Bank to use the
policy space opened up by the expected moderation in inflation and act early, recognizing the
imminent slowdown before it was confirmed by data subsequently. Monetary policy, however,
has its own limits. Structural reforms and fiscal measures may have to be continued and
further activated to provide a durable push to demand and boost growth. In my previous talks
elsewhere, I have highlighted certain potential growth drivers which, through backward and
forward linkages, could give significant push to growth. Some of these areas include prioritising
food processing industries, tourism, e-commerce, start-ups and efforts to become a part of the
global value chain. The Government is also focusing on infrastructure spending which will
augment growth potential of the economy. States should also play an important role by
enhancing capital expenditure which has high multiplier effect.
Concluding Remarks
27. Monetary policy frameworks in India has thus 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, however, the relative emphasis on inflation, growth and
financial stability has varied across monetary policy regimes. Although global experience with
financial stability as an added policy objective is still unsettled, the Reserve Bank has always
been giving due importance to financial stability since the enactment of the Preamble to the RBI
Act. The regulation and supervision of banks and non-bank financial intermediaries has rested
with the Reserve Bank and has kept pace with the prescribed global norms over time. More
recently, the focus of financial stability has not only confined to regulation and supervision but
also extending the reach of formal financial system to the unbanked and unserved population.
28. Apart from financial inclusion, there is also a focus on promoting secured, seamless and
real-time payments and settlements. This renewed focus on financial inclusion and secured
payments and settlements are not only aimed at promoting the confidence of general public in
the domestic financial system but also improving the credibility of monetary policy for price
stability, inclusive growth and financial stability.