Y V Reddy: Monetary policy - an outline
Presidential address by Dr Y V Reddy, Governor of the Reserve Bank of India, circulated in the Annual
Conference of Andhra Pradesh Economic Association, Visakhapatnam, 12 February 2005.
* * *
Respected Vice-Chancellor Professor Simhadri, Professor Bhanoji Rao, Professor K.C. Reddy, and
fellow-members of Andhra Pradesh Economic Association. I am thankful to the organisers for inviting
me to be the President and deliver the Presidential Address. There are several reasons for my being
keen to be in Visakhapatnam to deliver the Presidential Address. I commenced my career in
Government of Andhra Pradesh in Visakhapatnam as Assistant Collector Under Training over forty
years ago - in 1965. I had the benefit of professional guidance from eminent scholars and economists
in Andhra University such as Professors Sarveswara Rao garu, D.V. Ramana garu, G. Parthasarathy
garu, K.V. Ramana garu and S. Chandrasekhar garu. Subsequently, I acquired many friends with
strong links here, such as Professors Krishnamurthy garu and R. Radhakrishna garu. Professor
Bhanoji Rao garu has been a valued friend, whether he was in the World Bank with me, or in
Singapore or in the Administrative Staff College in Hyderabad. Professor K.C. Reddy garu worked
alongside me when I was the Secretary in Planning and Finance Department of the Government of
Andhra Pradesh. With all these attractions, I regret to say that I am not able to be physically present
in Visakhapatnam to deliver the Presidential Address at the 23rd Annual Conference due to
unavoidable official commitments.
The Andhra Pradesh Economic Association has been one of the pioneering efforts in our country in
organising a sub-national level professional body of economists. I have no doubt that it is a wise
initiative and needs to be carried forward. As the economic reform in India progresses, the relative
balance in public policy would shift in favour of the states relative to the centre. The important areas
earmarked for the centre, such as external sector and financial sector, tend to be subjected to
globalisation while in areas such as education, health, sanitation, roads, water works, power, etc.
which are localized in nature, states could have a greater role. Greater marketisation of economies
and private capital flows tend to look for conducive governance at the state-level where economic
activities are located. Hence, the state governments are well advised to take dynamic policy-initiatives
and it is in this background that the economists engaged at the state level have to play a crucial role in
the reform-process. In fact, there is some evidence of a positive link between education health and
other public services and economic growth. Interestingly, most states which have done well in terms of
investment and growth also have research institutes of repute in the area of social and economic
sciences.
Needless to say that, in this background, I am delighted to deliver the Presidential Address at the
Annual Conference of Andhra Pradesh Economic Association. In a conference of economists, it is
appropriate to go by the principle of comparative advantage, and accordingly I decided to focus my
comments on the core of my current professional as well as official preoccupation and talk on the
monetary policy.
In its conduct of monetary policy, the central bank responds to the evolving economic activity within an
articulated monetary policy framework. This framework would normally have three basic constituents,
viz.,
•
the objectives of monetary policy;
•
the analytics of monetary policy focusing on the transmission mechanism; and
•
the operating procedure focusing on operating targets and instruments.
For convenience, each of these issues has been dealt with separately and in this light, the Indian
experience has been touched upon briefly.
Objectives
Traditionally, central banks have pursued the twin objectives of price stability and growth. Central
banks have to keep in view the considerations of exchange rate stability and financial stability also in
pursuing the basic objectives. Can we achieve these objectives all at a time? As in most aspects of
life, the objectives of monetary policy are interrelated, and there are trade-offs as well. Illustratively,
economists often talk of the Phillips curve according to which there is a short-run negative relation
between inflation and unemployment. While there are various viewpoints on Phillips curve, in a world
where the Phillips curve is valid, a central bank can reduce inflation only at the cost of having more
unemployment. Similar trade-offs exist among other objectives as well.
Faced with multiple objectives that are equally desirable, there remains the problem of assigning to
each policy instrument the most appropriate objective. Accordingly, there is a broad consensus, both
in academic and policy circles, that monetary policy is useful as an instrument to achieving the goal of
price stability.
The adoption of price stability as the only objective of monetary policy is, however, by no means
universal. While a number of prominent central banks including the European Central Bank, Bank of
England and Bank of Japan have adopted price stability as the single objective of monetary policy, the
Federal Reserve of the US continues to pursue multiple objectives of monetary policy, viz., a)
maximum employment, b) stable prices, and c) moderate long-term interest rates. Central banks in
several developing countries have placed exchange rate management as another important policy
objective. In recent years, particularly after the financial crises of 1990s, the concern for financial
stability is an integral part of the central bank's activism.
Analytics of monetary policy
The process through which changes in the monetary policy get transmitted to the ultimate objectives
like inflation or growth has come to be known as "monetary transmission mechanism". Interestingly,
economists often refer to the channels of "monetary transmission" as a black box - implying that we
know that monetary policy does influence output and inflation but we do not know for certain how
precisely it does so. Nevertheless, in the literature, a number of transmission channels have been
identified: (a) the quantum channel (e.g., relating to money supply and credit); (b) the interest rate
channel; (c) the exchange rate channel; and (d) the asset price channel. How these channels function
in a given economy depends on the stage of development of the economy and its underlying financial
structure. Illustratively, in an open economy one would expect the exchange rate channel to be
important; similarly, in an economy where banks are the major source of finance (as against the
capital market), credit channel seems to be a major conduit for monetary transmission. Besides, it
needs to be noted that these channels are not mutually exclusive - in fact, there could be
considerable feedbacks and interactions among them.
Central banks may not be in a position to directly achieve their ultimate objectives and hence,
monetary policy is often formulated in terms of an intermediate target. For example, in a monetary
targeting framework, a suitable monetary aggregate is considered as an intermediate target based on
the basic relationship between money, output and prices. Exchange rate as an intermediate target can
be suitable for small open economies, setting the exchange rate against a low-inflation anchor country.
This may, however, entail loss of independence in steering domestic interest rates.
In this context, it is necessary to touch upon what is known as the 'impossible trinity', or 'trilemma' of
monetary policy. This refers to the incompatibility among three policy choices, viz., (a) fixed exchange
rate, (b) open capital account, and (c) independent monetary policy. The basic message of the
'trilemma' is that a central bank can achieve any two of the above-mentioned parameters, but not all
the three. Illustratively, if a country wants to have fixed exchange rate and independent monetary
policy then it is difficult to maintain an open capital account.
Another important issue in monetary policy is the extent of transparency. Central bankers all over the
world are not exactly known for clarity in their language. Nevertheless, the rational expectations school
in macroeconomics holds that no policy can be successful over a period by "fooling" the economic
agents. In this context, one may differentiate between genuine uncertainties about the future vis-à-vis
not revealing the expected outcome of the policy. In fact, since the 1990s, there has been a
preference all over the world to improve the transparency of monetary policy.
In the context of improving transparency, the recent trend has been towards direct inflation targeting.
Adoption of explicit inflation targeting as the final goal of monetary policy involves the preparation of
an inflation forecast, which, in a way, serves the purpose of both an intermediate target and final
objective. The pre-requisites for inflation targeting include a considerable degree of operational
autonomy or independence for central bank, flexible exchange rate conditions, well-developed
financial markets and absence of fiscal dominance.
In view of the growing complexities of macroeconomic management, several central banks including
the European Central Bank have placed reliance on a broad set of economic and leading indicators
rather than focusing exclusively on an intermediate target or a direct inflation target. The Federal
Reserve has traditionally been following a more broad based approach to the conduct of monetary
policy in the US.
Operating procedures: instruments and targets
Operating procedures refer to the day-to-day implementation of monetary policy by central banks
through various instruments. These instruments can be broadly classified into direct and indirect
instruments. Typically, direct instruments include required cash and/ or liquidity reserve ratios, directed
credit and administered interest rates. Cash reserve ratio (CRR) determines the level of reserves
(central bank money or cash) banks need to hold against their liabilities. Similarly, liquidity reserve
ratio requires banks to maintain a part of their liabilities in the form of liquid assets (e.g., government
securities). Credit and interest rate directives take the form of prescribed targets for allocation of credit
to preferred sectors/industries and prescription of deposit and lending rates.
The indirect instruments generally operate through price channel which cover repurchase (repos) and
outright transactions in securities (open market operations), standing facilities (refinance) and
market-based discount window. For example, if the central bank desires to inject liquidity for a short
period, it could do so by providing funds to the banks in exchange of securities at a desired interest
rate, reversing the transaction at a pre-determined time. Similarly, if the central bank desires to
influence liquidity on an enduring basis, it could resort to open market operations (OMO), involving
outright purchase (or sale) of securities.
While OMO including repo transactions operate at the discretion of the central bank, standing facilities
provide limited liquidity which could be accessed by the eligible market participants (generally banks)
at their discretion. Market-based discount window makes available reserves either through direct
lending or through rediscounting or purchase of financial assets held by banks.
In practice, the choice between direct and indirect instruments is not easy. While direct instruments
are effective, they are considered inefficient in terms of their impact on the financial market. On the
other hand, the use and efficacy of indirect instruments depends on the extent of development of the
supporting financial markets and institutions. These instruments are usually directed at attaining a
prescribed value of the operating target. Central banks typically adopt either (a) bank reserves or (b) a
very short-term interest rate (usually the overnight inter-bank rate) as the operating target.
The optimal choice between price and quantity targets would depend on the sources of disturbances
in the goods and money markets. In reality, it often becomes difficult to trace out the sources of
instability. Hence, monetary policy is implemented by fixing, at least over some short time interval, the
value of an operating target. In a single-period context, the choice of the level of the target amounts to
setting a rule for monetary policy. However, in a dynamic context, their connection is less
straightforward. Indeed, a deviation from a target could occur, either intended or unintended, which
may impart an inflationary bias when monetary policy is conducted with discretion. In order to address
such problems of dynamic inconsistency, rule-based solutions are emphasized in literature, e.g.,
monetary rule (changes in money supply at a pre-determined rate) and Taylor-type rule (changes in
interest rate based on deviation of growth and inflation from their potential/desired levels). While a
rule-based system imparts transparency, providing certainty about future policy response, it becomes
ineffective in its response to unanticipated shocks given its inflexibility. In practice, therefore, central
banks follow an approach of what has been best described as constrained discretion.
The operating procedures of monetary policy of most central banks have largely converged to one of
the following three variants: (i) estimate the demand for bank reserves and then carry out open market
operations to target short-term interest rates; (ii) estimate market liquidity and carry out open market
operations to target the bank reserves, while allowing interest rates to adjust; and (iii) modulate
monetary conditions in terms of both the quantum and price of liquidity, through a mix of open market
operations, standing facilities and minimum reserve requirement and changes in the policy rate with
the objective of containing overnight market interest rate within a narrow corridor of interest rate
targets.
Indian specifics
In this backdrop, let me now turn to the conduct of monetary policy in India.
What has been the objective of Indian monetary policy? The preamble to the Reserve Bank of India
Act, 1934 sets out the objectives of the Bank as "to regulate the issue of Bank notes and the 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". Although there is no explicit mandate for price
stability, as is the current trend in many countries, the objectives of monetary policy in India have
evolved as those of maintaining price stability and ensuring adequate flow of credit to the productive
sectors of the economy. In essence, monetary policy aims to maintain a judicious balance between
price stability and economic growth. The relative emphasis between price stability and economic
growth is governed by the prevailing circumstances in a particular time and is spelt out from time to
time in the policy announcements of the Reserve Bank.
Of late, considerations of financial stability have assumed greater importance in view of increasing
openness of the Indian economy and financial reforms. In the Indian context, financial stability could
be interpreted to embrace three aspects, viz., (a) ensuring uninterrupted financial transactions, (b)
maintenance of a level of confidence in the financial system amongst all the participants and
stakeholders, and (c) absence of excess volatility that unduly and adversely affects real economic
activity. It is the endeavour of the Reserve Bank to ensure all these aspects of financial stability.
As far as the conduct of monetary policy is concerned, it may be noted that monetary policy in India
used to be conducted till 1997-98 with broad money (M3) as an intermediate target. The aim was to
regulate money supply consistent with two parameters, viz., (a) the expected growth in real income,
and (b) a projected level of inflation. On the basis of estimates of these two crucial parameters, the
targeted monetary expansion could be set. In practice, the monetary targeting framework was used in
a flexible manner with feedback from developments in the real sector. However, questions were raised
about the appropriateness of such a framework with the changing inter-relationship between money,
output and prices in the wake of financial sector reforms and opening up of the economy. The Working
Group on Money Supply (1998) sought to address some of these issues. The most significant
observation of the Group was regarding the changing nature of transmission mechanism as it
highlighted that the interest rate channel was gaining in importance.
In line with this thinking, since 1998-99, the Reserve Bank has switched over to a multiple indicator
approach. As per this approach, interest rates or rates of return in different markets (money, capital
and government securities markets), along with data such as on currency, credit extended by banks
and financial institutions, fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing
and transactions in foreign exchange available on high-frequency basis, are juxtaposed with output for
drawing policy perspectives.
What is the operating procedure of monetary policy in India? In the current monetary policy framework,
with growing inter-linkages in the financial market, reliance on direct instruments has been reduced
and liquidity management in the system is carried out through OMO in the form of outright
purchases/sales of government securities and daily reverse repo and repo operations under Liquidity
Adjustment Facility (LAF). The LAF has enabled the Reserve Bank to modulate short-term liquidity
under varied financial market conditions, including large capital inflows from abroad. In addition, it has
enabled the Reserve Bank to set a corridor for the short-term interest rates consistent with the policy
objectives. This has also facilitated bringing down the CRR of banks without engendering liquidity
pressure. These operations are supplemented by access to the Reserve Bank's standing facilities. In
this new operating environment, changes in reverse repo and/or the Bank Rate have emerged as
interest rate signals.
There is no explicit interest rate target envisaged in India. Nevertheless, a great deal of reliance has
been placed in recent years on interest rates and exchange rates in the day-to-day conduct of
monetary policy. In the context of increasing openness of the economy and a market-determined
exchange rate, the large capital inflows witnessed in recent years have posed major challenges to the
conduct of monetary and exchange rate management. A critical issue in this regard is a view on
whether the capital flows are temporary or permanent in nature. The recent episode of large capital
flows prompted a debate in India on the need for exchange rate adjustment. In a scenario of
uncertainty facing the monetary authorities in determining temporary or permanent nature of inflows, it
is prudent to presume that such flows are temporary till they are firmly established to be of permanent
nature.
The liquidity impact of large inflows was managed till the year 2003-04, largely through the day-to-day
LAF and OMO. In the process, the stock of government securities available with the Reserve Bank
declined progressively and the burden of sterilization increasingly fell on LAF operations. In order to
address these issues, the Reserve Bank signed in March 2004, a memorandum of understanding
(MoU) with the Government of India for issuance of Treasury Bills and dated government securities
under the Market Stabilisation Scheme (MSS). The intention of MSS is essentially to differentiate the
liquidity absorption of a more enduring nature by way of sterilisation from the day-to-day normal
liquidity management operations. The ceiling on the outstanding obligations of the Government under
MSS has been initially indicated but is subject to revision through mutual consultation. The issuances
under MSS are matched by an equivalent cash balance held by the Government in a separate
identifiable cash account maintained and operated by the Reserve Bank. The operationalisation of
MSS to absorb liquidity of more enduring nature has considerably reduced the burden of sterilisation
on the LAF window.
In its monetary operations, the Reserve Bank uses multiple instruments to ensure that appropriate
liquidity is maintained in the system so that all legitimate requirements of credit are met, consistent
with the objective of price stability. Towards this end, the Bank pursues a policy of active management
of liquidity through OMO including LAF, MSS and CRR, and using the policy instruments at its
disposal flexibly, as and when the situation warrants.
Way ahead
Conduct of monetary policy is complex. It has not only to be forward looking but also to grapple with
uncertain future. Additional complexities arise in the case of an emerging market like India, which is
transiting from a relatively closed to a progressively open economy. In an environment of increasing
capital flows, narrowing cross-border interest rate differentials and surplus liquidity conditions,
exchange rate movement tends to have linkages with interest rate movements. The challenge of a
monetary authority is to balance the various choices into a coherent whole and to formulate a policy as
an art of the possible.
Let me now conclude by wishing this Conference all success.