Monetary Policy and Central Bank Communication
Address by Shri Shaktikanta Das, Governor
Reserve Bank of India
Delivered at the National Defence College, Ministry of Defence,
Government of India, New Delhi on March 4, 2022
I am happy to have been invited by the National Defence College
(NDC) to share some of my thoughts with the participants of the 62nd NDC
course on National Security and Strategic Studies. The NDC has earned
a reputation for being a centre of excellence in the study and practice of
National Security and Strategy. It is good to see a mix of officers of Armed
Forces and Civil Services from India as well as from other countries who
are participating in this course. In my experience, these inter-disciplinary
and cross-country gatherings, as in your case, provide the best
opportunities for learning and evolution of ideas.
2. Central banks remain at the heart of modern monetary and financial
systems. They have several instruments at their disposal to carry out their
wide-ranging mandate which includes monetary policy as the prime tool
to achieve macroeconomic stability. In this process, central banks through
their monetary policy operations influence longer-term interest rates,
overall economic activity and ultimately, prices. They aim to achieve price
stability (low and stable inflation) over a period of time while minimising
fluctuations in output and employment. Over time, the functions and
priorities of central banks have evolved in line with domestic and global
economic and financial developments and the prevailing political-
economic discourse. Yet, fostering monetary and financial stability has
always remained the most important policy anchor of a central bank in its
pursuit of achieving maximum sustainable levels of output in the economy.
This is aptly reflected in the Preamble to the Reserve Bank of India Act,
1934 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".
3. In my talk today, I shall focus on the evolution of ideas that shaped
Indian monetary policy. Monetary policy is not merely a science where we
tweak some instrument to achieve an objective. It is also an art of creating
new instruments and taking policy calls in response to anticipated and
evolving challenges and communicating them with prescience and clarity,
especially during crisis times. Decisiveness, timing and communication
are key to effective monetary policy. In my address today, I propose to
dwell upon aspects of monetary policy and central bank communication.
Evolution of Monetary Policy in India
Early Phase
4. The evolution of the Reserve Bank's monetary policy framework has
closely tracked economic and financial development of our country. After
independence, India pursued a policy of planned economic development.
Monetary policy, therefore, largely focused on expanding the availability
and access to credit for the development needs of the economy. This was
followed by mounting inflationary concerns in the 1960s and 1970s on
account of deficit financing, frequent supply shocks in agricultural sector,
global oil price shocks of 1973 and 1979, and the collapse of the Bretton
Woods system in 19731. During these times, inflation control was largely
based on price controls by the Government and selective credit controls
and moral suasion by the Reserve Bank to restrain banks from extending
credit for speculative purposes.
Monetary Targeting
5. Against the backdrop of high inflation amidst rising fiscal
dominance, a rule-based monetary targeting framework was adopted on
the recommendations of the Sukhamoy Chakravarty Committee (1985).
In this framework, reserve money was used as the operating target while
broad money served as the intermediate target for controlling inflation by
regulating monetary expansion consistent with inflation and growth
objectives2. Nonetheless, due to continued expansionary fiscal policy,
both the statutory liquidity ratio (SLR) and the cash reserve ratio (CRR)
had to be progressively increased in the 1980s to reach their peak levels
by the early 1990s3. The pre-emption of resources through CRR and SLR
reduced the space for meeting the credit requirements of the economy. In
the wake of trade and financial sector reforms in the early 1990s and the
consequent rise in foreign capital flows, financial innovations and a
notable shift towards market-based financing, the monetary targeting
framework that rested on the assumption of a stable relationship between
money, output and prices came under scrutiny towards the later part of
the 1990s.
Multiple Indicators Approach
6. With questions on the efficacy of the prevalent monetary targeting
framework, the Reserve Bank of India adopted multiple indicators (MI)
approach in April 19984. In the MI approach, there was a greater emphasis
on interest rate vis-à-vis quantity channels (money supply) for monetary
policy formulation. Interest rates in different markets (money, capital and
government securities markets) along with high frequency data on
currency, credit extended by banks and financial institutions, fiscal
position, trade, capital flows, inflation rate, exchange rate, among others,
were juxtaposed with output data for drawing policy perspectives. In other
words, policy emphasis shifted to price of credit (i.e., interest rate) rather
than quantity of credit. Accordingly, short-term interest rates became key
instruments in signalling the monetary policy stance of the RBI. The
liquidity operations of the RBI were geared to align market rates with the
policy stance. The MI approach served well by delivering low inflation and
high growth prior to the global financial crisis.
Flexible Inflation Targeting
7. In the post global financial crisis (GFC) period and, particularly, after
the taper tantrum episode of 2013, the credibility of the MI framework
came into question as persistently high inflation and tepid growth began
to co-exist. The MI approach with its focus on a large set of indicators did
not provide a clearly defined nominal anchor for monetary policy. An
Expert Committee set up by the RBI to revise and strengthen the
monetary policy framework, in its report submitted in January 2014,
recommended that inflation, defined in terms of headline consumer price
index (CPI) inflation - CPI-Combined - should be the nominal anchor for
monetary policy. India formally adopted flexible inflation targeting (FIT)
with the amendment of the RBI Act in June 2016. The amended Act states
the role of the RBI in monetary policy as follows: "the primary objective of
monetary policy is to maintain price stability while keeping in mind the
objective of growth".
8. The amended Act also explicitly recognised that it is essential to
have a monetary policy framework to meet the challenges of an
increasingly complex economy and that the monetary policy framework
shall be operated by the Reserve Bank of India. Price stability under the
statute has been defined numerically by a target of 4 per cent for headline
CPI with a tolerance band of +/- 2 per cent around it. The flexibility in the
FIT regime comes from provisions to accommodate or see-through
transitory supply side shocks to inflation. Failure to meet the monetary
policy objective is defined in terms of average headline CPI inflation
remaining lower or higher than the 2 to 6 per cent band for three
consecutive quarters, rather than any instance where inflation exceeds /
falls below the target. This helps monetary policy to avoid undue volatility
in rate setting behaviour that may adversely impact growth. The repo rate
was defined as the policy rate and a monetary policy committee (MPC)
was set up in the RBI - with both internal and external members - to
determine the repo rate with the objective of achieving the mandated
inflation target. The MPC resolution containing the committee's
assessment and outlook on growth and inflation, including numerical
projections, the repo rate decision and the rationale thereof is released
immediately after the MPC meeting along with voting pattern of the
members. Statements of Individual members covering their own
assessment and justifications for their decision are released 14 days after
the meeting in the minutes.
9. The clearly defined inflation target and the band, the setting up of
the MPC, the explicit accountability mechanisms for defining failure in
meeting the target, the detailed resolution and the quick release of
individual assessments in the minutes have strengthened transparency
and credibility of monetary policy formulation in India. Overall, a
consensus has emerged post-GFC around a holistic approach that
focused on inflation targeting as well as macro-financial stability. It is
interesting to note that the central banks' function as the lender of last
resort (LOLR) has remained intact, notwithstanding the developments and
refinements in the policy frameworks across countries, including India.
Within the broad objectives, however, the relative emphasis on inflation,
growth and financial stability has varied across both monetary policy
regimes as well as in different phases of the business cycle. Although
global experience - with financial stability as an added policy objective -
is still evolving, the Reserve Bank has always been giving due importance
to financial stability risks through active use of macro-prudential policy
tools.
10. The FIT framework has served us well since its inception in 2016
even as the economy faced a sequence of shocks in this period. The
framework's flexibility and efficacy were tested significantly in the past
couple of years as we have been grappling with the once in a century
crisis, the COVID-19 pandemic. The flexible framework allowed the MPC
to continue with the accommodative monetary policy stance in support of
growth even as inflation intermittently touched or exceeded the upper end
of the inflation band due to large supply shocks and other bottlenecks.
This was facilitated through prescient communication - as FIT is
essentially a forward-looking framework. Emphasis was given on
communicating the rationale of policy measures and decisions with clarity
which is crucial for conditioning market expectations.
Role of Communication
Global Context
11. Only a few decades ago, central banks were shrouded in secrecy
and their work was viewed as esoteric and beyond the reach of the
common people. Central banks worked in not so open or transparent
manner and perhaps believed that policy traction came from surprising
the market. Their communication often bordered on being delightfully
vague, mystifying and remarkably opaque, often labelled as "constructive
ambiguity"5. Who can forget the famous quote of the US Fed's former
chairman Alan Greenspan: "Since I've become a central banker, I've
learned to mumble with great incoherence. If I seem unduly clear to you,
you must have misunderstood what I said"6.
12. In contrast, communications of central banks today are known for
their clarity, precision, accountability and transparency. This change has
occurred mainly because of two reasons. First, as central banks became
more independent in their areas of operation, they also needed to be more
transparent and accountable in a democratic set up to garner public trust.
Second, central banks have increasingly used communication as an
instrument of monetary policy to condition market expectations that is
essential for efficient and effective transmission of monetary policy
signals7. The behaviour of forward-looking economic agents - firms and
consumers - is influenced more by their future expectations of interest
rates, prices and incomes rather than just the current changes in these
variables. Accordingly, central banks offer forward guidance - both implicit
and explicit - to manage expectations in the economy. Thus,
communication is an extremely potent component of the toolkit of modern
central banks.
13. Communication, however, is also a double-edged sword. During the
global financial crisis, a coordinated response by the major central banks
helped avert the worst effect of the crisis. Mr. Mario Draghi's declaration
as the President of the European Central Bank to do "whatever it takes"
to preserve the euro amidst the eurozone debt crisis of July 2012 boosted
market sentiments. On the other hand, communication by the US Fed
during May 2013 on its future monetary policy path triggered the taper
tantrum episode of heightened global financial market volatility as markets
were caught off guard by the announcement. Therefore, communication
needs to be balanced and well-telegraphed to avoid unintended
consequences.
14. The current global conditions, after about two years of living through
the pandemic, are now posing complex challenges for central bank
communication. A number of economies, including the major ones, are
facing multi-decadal high inflation due to supply disruptions, tighter labour
markets, fragility of the just in time inventory management and geo-
political disturbances. Central banks are in a bind - if they act aggressively
to contain inflation which may perhaps subside as normalcy returns, they
run the risk of setting in recession; on the other hand, if they act too little
and too late, they may be blamed for "falling behind the curve" and may
have to do a lot of catching up later which will be detrimental to growth.
Meanwhile, financial markets world over have turned extremely volatile as
they have been left grappling with heightened uncertainty over the pace
of future monetary policy normalisation. Recent geo-political
developments have further aggravated the challenges and dilemmas for
the central banks. Amidst these uncertainties, central banks have to find
the optimal grounds with attendant communication challenges.
Our Recent Approach
15. At the Reserve Bank, we are mindful of the importance of
communication given our multifarious responsibilities and wider
ramifications of our actions. We have followed a consultative approach by
periodically interacting with various stakeholders on policy formulation.
This has particularly served us well in designing appropriate policy
responses, especially during the pandemic. We believe in two-way
communication for informed policy decisions. With this objective, we hold
detailed interactions with analysts, economists, researchers, banks,
academic bodies and research institutions, trade and industry
associations, and several others. We have followed this approach not only
for the much-publicised monetary policy actions but also for other policies.
We also recognise that communication needs to be backed by
commensurate actions to build credibility and instil wider confidence in our
policies. We explain the rationale of our actions in the best traditions of
accountability and transparency, the hallmark of a modern market-based
approach to monetary policy making.
16. As part of our monetary policy, we have actively used
communication through a variety of tools - the MPC resolutions and
minutes, my exhaustive post-policy statements together with statement on
developmental and regulatory measures, press conferences, speeches
by me and my colleagues, and our other publications, especially the bi-
annual Monetary Policy Report (MPR) - to anchor expectations. Our
policies, especially the relative emphasis on inflation and growth are
always based on an objective assessment of all relevant factors; and we
make it a point to communicate our policy decisions, including through
interactions with the media, to facilitate clarity in understanding. During
2019 when we embarked upon a cycle of rate cuts and change of stance
from 'calibrated tightening' to 'neutral' and then to 'accommodative', the
accompanying communications were unambiguous. On various
occasions, we had stated "it is vital to act decisively and in a timely
manner" to support growth; "to boost aggregate demand, and in particular,
private investment activity"; and similar other pronouncements to provide
market guidance.
17. With the declaration of COVID-19 as a pandemic in March 2020,
communication became more challenging as we had only digital interface
with media and market participants while at the same time we had to
undertake several emergency conventional and unconventional
measures as the crisis unfolded. The Governor's statement of March 27,
2020 highlighted that the outbreak of the pandemic warranted not only an
advancement of the date of MPC meeting, but it also merited "a sizeable
reduction of 75 basis points in the policy repo rate" which was "intended
to (i) mitigate the negative effects of the virus; (ii) revive growth; and above
all, (iii) preserve financial stability." The statement unfurled several other
measures to combat the pandemic while providing the much needed
optimism by stating "it is worthwhile to remember that tough times never
last; only tough people and tough institutions do". The message was clear
- we need to stand firm, maintain resilience and do whatever it takes to
deal with the situation.
18. These decisive and timely measures, which eased financial
conditions while unfreezing the markets considerably, got reflected in
reduced spreads on money and bond market instruments and higher
trading volumes in corporate bonds. Reiterating optimism, it was noted in
my April 17, 2020 statement that "Although social distancing separates
us, we stand united and resolute. Eventually, we shall cure; and we shall
endure". In May 2020, sensing that "the macroeconomic impact of the
pandemic is turning out to be more severe than initially anticipated", the
MPC decided to reduce the policy repo rate further by 40 basis points.
The Governor's statement concluded with the words "Today's trials may
be traumatic, but together we shall triumph".
19. The Reserve Bank's response at the height of the pandemic was
prompt and decisive. More than 100 measures were undertaken since
March 2020. Moreover, on two occasions - March and May 2020 - the
MPC meetings were held ahead of the schedule; while two other
standalone statements were made by the Governor outside the Monetary
Policy Committee (MPC) cycle - one in April 2020 in the early days of
COVID-19 crisis and the other in May 2021 at the peak of the second
wave. These off cycle MPC meetings and standalone statements
demonstrated the RBI's readiness to undertake pre-emptive actions. We
were perhaps the only central bank in the world to have set up a special
quarantine facility with about 200 officers, staff and service providers,
engaged in critical activities to ensure business continuity in banking and
financial market operations and payment systems.
20. In October 2020, supply-side pressures had taken inflation above
the tolerance band of 2 to 6 per cent and there were market concerns over
the continuation of the accommodative monetary policy stance, even as
output was well-below its pre-pandemic level. Given these circumstances,
the MPC reinforced its forward guidance by supplementing state-
contingent forward guidance with time-contingent guidance by stating its
intent to continue "with the accommodative stance of monetary policy as
long as necessary - at least during the current financial year and into the
next year ...". Inflation eased in the second half of 2020-21 in line with the
MPC's assessment as supply side pressures abated. The time-based
element of the guidance did help to anchor market expectations and
moderate undue expectations building up at that time of a possible
reversal of the monetary policy stance.
21. Communication exemplifying explicit forward guidance, whose role
and nature is continuously evolving, came to the fore in April 2021 on the
eve of the virulent second wave of infections. The MPC reverted from both
state- and time-based forward guidance to state-based guidance,
realising that "it is difficult to perfectly foresee how the economy evolves
and when the recovery gets firmly entrenched given the persistence of the
pandemic." The RBI instituted a secondary market G-sec Acquisition
Programme (G-SAP) which provided an upfront commitment to a specific
amount of open market purchase of government securities, in order to
assuage market concerns on the size of the government borrowing
programme for 2021-22 and its impact on interest rates in the bond
market. This measure, combined with the explicit recognition that the yield
curve is a public good whose orderly evolution is the shared responsibility
of both market participants and the Reserve Bank, benefited all
stakeholders by anchoring yield expectations and provided a benchmark
for the pricing of other financial instruments.
22. Recalibrating the pandemic time policy path, as and when the
situation warrants, would present its own share of communication
challenges. For RBI's crisis measures announced with pre-specified
terminal dates, market expectations remained anchored and
communication challenges were minimal when these measures got
automatically withdrawn. On the other hand, measures or unwinding of
open-ended policies, as and when they happen, would require careful,
nuanced and measured communication as in such instances, the
expectations of certain segments of the market may not be in sync with
that of the central bank's assessment. Illustratively, the Governor's policy
statement of February 2021 addressed the fears of reversal of monetary
policy which were building up due to resumption of variable rate reverse
repo (VRRR) operation in January 2021, by explaining the rationale for
the reintroduction of VRRR more explicitly. Similarly, liquidity rebalancing
was set in motion in August 2021 through periodic upscaling of the 14-day
main VRRR auction so as to ensure that liquidity conditions "evolve in
sync with the macroeconomic developments to preserve financial
stability". In the same spirit, G-SAP operations were discontinued in
October 2021 given "the existing liquidity overhang, the absence of a need
for additional borrowing for GST compensation and the expected
expansion of liquidity in the system ...".
23. As I proceed to conclude, let me briefly summarise how we have
been different from other central banks in our pandemic response. First,
we have undertaken unconventional measures even before exhausting
the conventional policy space; i.e., even before reaching the zero lower
bound of interest rates. Second, the counterparties involved in our
operations were only banks and All India Financial Institutions (AIFIs) as
liquidity provided to targeted sectors were channelised through them.
Third, we have confined our asset purchase programme to central and
state government securities and have not diluted RBI's collateral
standards in our lending operations, unlike many other central banks.
Fourth, most of our measures were announced with pre-set terminal dates
instead of being open-ended. This has reinforced the credibility of our
announcements. Fifth, while stating and in facilitating the "evolution of the
yield curve as a public good", we have solely operated in the secondary
market unlike some inflation targeting EME central banks that made
emergency provisions to operate in the primary market to finance the
government directly. Sixth and finally, we have continued with our
accommodative stance based on our own domestic growth-inflation
dynamics, amidst current divergence in policy actions of central banks
across the world. Thus, we have used the flexibility embedded in the FIT
framework and implemented our monetary policies, without compromising
on our primary mandate of price stability. The raison d'être of our actions,
as I mentioned earlier, was communicated through speeches, post-policy
press conferences and media interactions.
Concluding Observations
24. Let me conclude by saying that 'change' has been the only constant
in the theory and practice of monetary policy. There is no last word yet on
what constitutes the best practice of monetary policy. The conduct of
monetary policy has undergone notable changes both in India and across
the world as economies and markets evolved and policymakers gained
greater insights into how economic agents interact in a complex economic
system.
25. Globally, the evolution of monetary policy has swung from being
more directive and discretionary to a strict rule-based regime, before
settling to the current consensus for a pragmatic mix of rules and
discretion. In this process, communication has gained importance
although it works both ways - while too much of communication can
confuse the market, too little may keep it guessing about the central
bank's policy intent. Therefore, central banks have to tread a very fine
line. As monetary policy is an art of managing expectations8, central banks
have to make continual efforts to shape and anchor market expectations,
not just through pronouncements and actions but also through a constant
refinement of their communication strategies to ensure the desired
societal outcomes. This is, however, an iterative process and central
banks are only getting better at it incrementally.
Thank you. Stay well. Namaskar!
8
Michael D. Woodford (2003), Interest and Prices: Foundations of a Theory of Monetary Policy,
Princeton University Press.