Deepak Mohanty: Unconventional monetary policy - the Indian
experience with crisis response and policy exit
Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the
Reserve Bank Staff College (RBSC), Chennai, 26 December 2013.
* * *
The assistance provided by Binod B. Bhoi and Rajeev Jain in preparation of this paper is acknowledged.
Accompanying charts can also be found on the Reserve Bank of India's website: http://www.rbi.org.in/scripts/bs_
viewspeeches.aspx
I thank Principal Uma Subramaniam for this opportunity to interact with you on
unconventional monetary policy. The seminar is topical and timely. It is now 5 years since the
collapse of the Lehman Brothers in September 2008, which evoked unprecedented monetary
policy activism - both conventional and unconventional - across the advanced and emerging
market economies (EMEs). It is for the first time on December 18, 2013 that the US Fed
announced concrete measures to exit from unconventional monetary policy in a calibrated
manner starting January 2014.
The Indian economy like other EMEs was affected both by the global financial crisis
postLehman and the announcement of likely exit by the US Fed in May 2013. We also resorted to
both conventional and unconventional policies not only in response to the crisis but also to
the announcement of exit, though there were qualitative differences in these responses.
Against this backdrop, I will begin by distinguishing unconventional monetary policy from
conventional policy, highlight the contours of unconventional policies in major advance
economies and review the impact of such policies. I will then turn to the impact on India and
our monetary policy response. I will end by drawing a few broad conclusions.
Conventional and unconventional monetary policy
Conventional monetary policy is understood as central banks operating with a short-term
policy interest rate in the money market to signal the stance of monetary policy and in the
process influence the term structure of market interest rates to achieve the objectives of price
stability with sustainable growth. Price stability is not an end in itself. Price stability, defined
as a low and stable inflation, is considered a prerequisite for sustainable growth over the
medium-term. It is believed that there is no trade-off between growth and inflation over the
medium-term. Even countries which have chosen inflation targeting framework try to stabilise
output around its potential and inflation around its target level. Hence, normally in the event
of a shock when either or both the parameters drift from their targets, the objective is to bring
it back to target over the medium-term. However, conventional monetary policy has a limiting
condition of "zero lower bond". For example, in the event of an extreme shock, as it
happened during the global financial crisis, when policy rates were brought down close to
zero, further monetary stimulus was not possible through conventional monetary policy.
When central banks look beyond their traditional instrument of policy interest rate, monetary
policy takes an unconventional character. It essentially means using quantity instruments for
expanding the balance sheet of the central bank. It can take different forms: quantitative
easing (QE) through direct long-term asset purchase by the central bank, credit easing (CE)
by the central bank directly intervening in a particular segment of the credit market. Both QE
and CE can be accompanied by dilution of collateral standards by the central bank
expanding the list of collateral beyond its traditional preference for low risk sovereign bonds.
Unconventional monetary policy is invariably accompanied by forward guidance regarding
the future path of monetary policy to work on the expectations channel. This is because the
efficacies of asset purchases programme depend on the behaviour of market participants
and financial entities. It is likely that market participants may not alter their behaviour without
knowing what the central bank will do in the future with regard to these instruments.
In the event of a crisis, it is not unusual for central banks to expand their balance sheets. The
greatest received wisdom in central banking is the lender of last resort (LOLR) function
based on the Bagehot principle that, "the central bank should lend freely against good
collateral at a penal rate"1. In fact, many early central banks including the US Fed were
instituted to largely discharge this function. Monetary policy as we understand today was
alien then. It is a different matter that the recent global financial crisis tested the limits of
Bagehot principle as never before.
Contours of unconventional monetary policy
Let me now turn to how the US Fed, the European Central Bank (ECB), the Bank of England
(BoE) and the Bank of Japan (BoJ) unveiled their unconventional monetary policies. I may
mention that the BoJ was using unconventional monetary policy much earlier as Japan went
into prolonged deflation from the late 1990s.
The global financial crisis which erupted with collapse of major financial institutions in
advanced economies was unprecedented in its scale. Not only did it lead to a sharp decline
in asset prices, freezing of credit markets, and the loss of confidence in the building blocks of
the financial system, its impact was magnified through quick transmission to other economies
as well. Monetary authorities in the advanced economies were the first to resort to
aggressive monetary easing first by reducing policy rates. However, key channels of
conventional monetary policy were severely impaired during the crisis as policy rates in most
advanced economies approached zero lower bound (Chart 1).
Taking cognisance of the severity of the crisis and concerns of economic recession, central
banks used their balance sheets in unconventional ways to augment liquidity (Table 1). The
QE programmes initially attempted to alleviate financial market distress, but this purpose
soon broadened to include achieving inflation targets, stimulating the real economy, and
containing the European sovereign debt crisis (Fawley and Neely, 2013)2. Now let us discuss
a little about the rationale for unconventional policies undertaken across major economies.
Table 1
In the US, immediately after the collapse of Lehman Brothers, when slow growth and high
unemployment emerged as major concerns, the Fed announced the policy of quantitative
easing (QE) in November 2008. The first two rounds of QEs reactivated financial markets,
but failed to spur growth. Under "Operation Twist" instituted in September 2011, the Fed took
initiative of buying longer-term Treasuries and simultaneously selling some of the
shorterdated securities to bring down long-term interest rates which continued till December 2012.
With a view to putting in place a stronger version QE, it launched QE3 in September 2012.
Under QE3, the Fed started purchasing US$85 billion of fixed-income securities per month.
The Fed intended to keep QE3 in effect until unemployment falls to 6.5 per cent or inflation
rises to 2.5 per cent. In addition to QE3, the Fed gave a forward guidance that it would keep
short-term rates low through 2015. As economic parameters showed improvement, the Fed
started talking about exit, popularly known as the tapering of bond buying in May 2013.
Subsequently, it announced to slow the pace of the bond buying program by US$ 10 billion
per month from January 2014.
In the UK, after reducing the policy rate (i.e., Bank Rate) to 0.5 per cent in March 2009, the
Bank of England (BoE) started its asset purchase programmes which consisted almost
exclusively of government bonds from the non-bank private sector. Subsequently, the
Funding for Lending Scheme (FLS) was put in place in July 2012 with the aim of incentivising
banks and building societies to boost their lending to the UK real economy3.
Japan's economy had deteriorated for nearly 15 years under the threat of deflation. To
overcome deflation, the Bank of Japan (BoJ) engaged in a wide range of monetary easing
efforts - including the implementation of the zero interest rate policy, the quantitative easing
policy and comprehensive monetary easing, but there have been no easily derived concrete
results4. Following the crisis, the BoJ embarked on an ambitious asset purchase program to
combat deflation. In October 2012, it announced purchase of Japanese government bonds
(JGBs), commercial paper, corporate bonds, exchange traded funds (ETF), Japanese real
estate investment trusts (J-REITS). In April 2013, BoJ announced Quantitative and
Qualitative Monetary Easing Program under which it purchases JGBs, ETFs and J-REITs
with the goal of increasing the monetary base by 60-70 trillion JPY annually, increasing the
average maturity of JGBs held from three to seven years and meeting the 2 per cent inflation
target in about two years.
In the euro area, concerns over counter-party risk eventually led to drying up of interbank
lending by early 2009. The European Central Bank (ECB) responded in May 2009, by
reducing its main refinancing rate to 1 per cent and by introducing 12-month LTROs and the
covered bond purchase program (CBPP). The ECB substantially extended its liquidity
provision by offering unlimited longer-term refinancing operations. The ECB also purchased
some securities outright in distressed markets through its securities markets program (SMP),
which was, however, later replaced by the pledge to intervene more decisively through
Outright Monetary Transactions (OMTs).
The unconventional measures undertaken have involved extraordinary central bank lending,
expanding central bank balance sheets substantially (Chart 2). We learn from text books and
the inflation experiences of the 1970s that a sharp increase in base money could be
inflationary. On the contrary, in the current episode inflation declined below target levels in
many advanced countries.
Partly the explanation lies in the fact that despite such increase in the size of balance sheets,
broad money supply did not expand significantly. This was due to perceptible decline in
money multiplier on account of banks building up cash reserves on being risk averse and to
conserve on required capital rather than lending to the real economy (Chart 3). Moreover, with
interest rates at near zero level, the opportunity costs of holding money for the money holding
sector also fell. Another interesting explanation is that inflation expectations remained well
anchored, meaning once economic entities believe that inflation will not go up it does not go
up. Further, with the economy operating below its capacity the scope for inflation from wage
increase is not there. While consumer price inflation may not rise in the short run, it cannot be
presumed that asset price inflation will not go up given the excess liquidity.
The large scale economic downturn accompanying the financial crisis also led to activation of
counter-cyclical fiscal policy of unprecedented magnitude. The fiscal measures focused on
improving the balance sheet of the financial and corporate sectors as reflected in large scale
bailouts in the US and other advanced economies. Reflecting such fiscal stimulus measures,
advanced economies witnessed significant deterioration in their fiscal position as reflected in
high public debt to GDP ratios (Chart 4). Let me now turn to the experience of EMEs.
Experience of EMEs
Initially, it was viewed that EMEs would remain insulated from global financial meltdown on
the back of the significant buffers they have built over the years, which included substantial
foreign exchange reserves, improved policy frameworks and generally robust banking sector
and corporate balance sheets. However, as the crisis deepened following the failure of
Lehman Brothers and resulted in heightened risk aversion and global deleveraging, the
EMEs were also affected in varying degrees.
The contagion from the global financial crisis also warranted swift monetary and fiscal policy
responses in EMEs with a view to ensuring orderly functioning of markets, preserving
financial stability, and moderating its adverse effects on growth. In the process, their policy
responses became more synchronised with global efforts (Mohanty, 2011)5.
While both developed economies and EMEs resorted to conventional and unconventional
monetary measures, there were certain differences in terms of their timing, types and
magnitudes. First, while in the advanced economies the switchover was from conventional
monetary tools to unconventional measures due to policy rates approaching zero, in many
EMEs, unconventional foreign exchange easing and domestic liquidity augmenting measures
preceded the conventional measures of policy rate cuts. Second, while central banks in
EMEs relied mostly on direct instruments such as reserve requirements to ease domestic
liquidity, central banks in advanced countries resorted to various liquidity providing
operations through relaxation of counter-parties, collaterals and maturity. Third, central banks
in advanced countries extensively used credit and quantitative easing measures which led to
large expansion of their balance sheets unlike in EMEs. Fourth, while in advanced
economies fiscal support aimed at rescuing the financial sector from the crisis situation, in
EMEs they were generally meant to address the deficiency in aggregate demand. Let me
now turn to some of the consequences of unconventional policy.
Impact of unconventional policies
As most of the unconventional monetary policy measures were undertaken keeping in view
the domestic economies, the attendant increase in global liquidity appears to have impacted
a range of asset classes in both advanced and emerging economies (Chart 5). There are
studies which find significant impact of QE. They suggest reduction in US treasury yields
around 100 basis points, corporate bond yields by 80 basis points, and reduction in the range
of 20-80 basis points in other advanced economies6. In case of some EMEs, the evidence
suggested high capital inflow pressure, rapid domestic credit growth and domestic
inflationary pressures.
Furthermore, indications about the possible withdrawal since the talk about US taper in May
2013 has caused volatility in financial markets in EMEs and impacted currency valuations as
capital retreated back to the US in anticipation of higher interest rates. EMEs, particularly
with large current account and fiscal deficits, were severely impacted. Let me turn to our
experience with the crisis, and now with the talk of taper.
Indian experience with the crisis and policy exit
Until the emergence of the global crisis, India had experienced a phase of high growth along
with low and stable inflation. Growth was largely driven by high domestic demand - growing
domestic investment financed mostly by domestic savings and sustained consumption
demand. Sequential financial sector reforms, rule-based fiscal policy and forward looking
monetary policy together contributed to the overall improved macroeconomic performance.
Following the emergence of the crisis, India, initially remained somewhat insulated to the
global developments, but eventually was impacted significantly through all the channels -
financial, real and more importantly, the confidence channel (Subbarao, 2009)7. This could
be attributed to the global nature of the crisis on the one hand and accelerated trade and
financial integration of the Indian economy with the world on the other.
The impact of the crisis was first visible on India's financial markets in the form of tightening
of liquidity and higher volatility in all market segments along with sharp decline in stock
prices. Risk aversion on the part of global investors resulted in moderation in capital inflows
and exchange rate depreciation. Credit growth decelerated reflecting weakening business
confidence. Growth, which was already on a cyclical moderation in the first half of 2008-09,
decelerated significantly during the second half. As a result, growth declined to 6.7 per cent
in 2008-09 from the preceding 5-year average of 8.7 per cent per annum (Table 2).
Table 2
Restoring normalcy in financial markets, ensuring normal flow of credit to productive sectors
of the economy as well as limiting the adverse impact on the real sector of the economy
assumed policy priority. The Reserve Bank, like most other central banks, took a number of
conventional and unconventional measures to limit the adverse impact of the contagion on
the Indian financial markets and the economy. These included augmenting domestic and
foreign exchange liquidity and a sharp reduction in the policy rate. The Reserve Bank used
multiple instruments such as the liquidity adjustment facility (LAF), open market operations
(OMO), cash reserve ratio (CRR) and securities under the market stabilisation scheme
(MSS) to augment the liquidity in the system.
These measures were supported by fiscal stimulus packages which raised the fiscal deficit of
the Central Government by about 3.5 per cent of GDP to 6.0 per cent in 2008-09 (Chart 6).
On the back of substantial monetary and fiscal stimulus, growth bounced back quickly.
However, inflation also picked up. Consequently, the policy focus shifted to exit from
accommodative monetary policy in a calibrated manner starting in October 2009. To begin
with all special liquidity measures were withdrawn which was followed by hikes in policy rate.
As the real policy rate turned positive it started to have an impact on inflation.
Going into the financial year 2012-13, growth declined and headline WPI inflation showed a
clear sign of moderation. This prompted the Reserve Bank to reduce the policy rate
(Chart 7).
As the economic conditions appeared to be stabilising, volatility in the financial market
returned following the announcement in May 2013 of the Fed's intention of likely tapering of
QE. This prompted the Reserve Bank to resort to somewhat unconventional monetary policy
measures besides drawing down of foreign exchange reserves to meet the immediate
shortfall (Chart 8). Let me give you the flavour of key measures.
• In terms of monetary policy, the upper bound of the policy rate corridor (i.e., MSF
rate) was raised by 200 basis points and the quantity of central bank liquidity
available through the LAF window was restrained. This had the desired effect of
tightening the monetary conditions and raising the effective policy rate sharply to the
MSF rate.
• In order to signal that the above measure is temporary so that the interest rates at
the longer end do not harden a form of operation twist was tried by conducting
outright OMO purchase of government securities alongside sale of short-term
government cash management bills. This inverted the yield curve, though
accompanied by some increase in long-term rates.
• With a view to containing the current account deficit (CAD) on the balance of
payments (BoP), gold imports were restricted.
• The non-resident deposit schemes and banks' borrowing abroad were further
liberalised with incentives for swapping these inflows directly with the Reserve Bank.
This substantially augmented foreign exchange reserves despite some outflow on
account of directly meeting the foreign exchange requirement of oil imports.
As portfolio capital outflows waned and BoP improved, stability returned to the foreign
exchange market. This prompted the Reserve Bank to unwind the bulk of the exceptional
measures and normalise monetary policy by restoring the policy interest rate corridor to its
original position and the repo rate to its signalling role of policy. Though the policy repo rate
was increased by 25 basis points each in September and November 2013, this was more on
considerations of emerging growth and inflation balance.
Conclusion
Let me conclude.
First, the global financial crisis triggered unprecedented policy activism by advance country
central banks. They resorted to unconventional monetary policy of the nature and scale
unthinkable hitherto.
Second, as we complete over 5 years of unconventional monetary policy of QE and CE, the
question is: did it succeed? While it is too early to say, opinion remains divided. Thus far,
with unconventional policies, the central banks have been far less successful in stimulating
growth8. While it may not have improved general monetary transmission and prompted
sustainable recovery, it did have significant impact on the financial market. The
counterfactual of what would have happened without QE is not known? In any case, it seems
to have prevented a deeper recession.
Third, the spillover effect of QE on commodity markets and emerging market economies
(EMEs) has been significant. This has resulted in increased volatility of capital flows and
elevated asset prices. The initiation of exit from QE has also created additional
macroeconomic challenges for EMEs including India.
Fourth, the Indian economy and financial markets were significantly impacted by the global
financial crisis and the recent signalling of exit from QE by the Fed. This prompted the
Reserve Bank to resort to both conventional and unconventional monetary policy alongside
other regulatory policies to stabilise markets.
Finally, while the exit from QE increases uncertainties in the financial market, it is
increasingly felt that continuation of unconventional monetary policy for long could create
risks in the global economy it sought to address by preventing deleveraging and appropriate
pricing of risks. In addition, the current policy response has increased sovereign risk in a
number of countries which circumscribes the ability of policy to cushion further unexpected
shocks.
Thank you.