Y V Reddy: Parameters of Monetary Policy in India
Lecture by Dr Y V Reddy, Deputy Governor of the Reserve Bank of India, at the 88th Annual
Conference of The Indian Econometric Society at Madras School of Economics, Chennai,
15 January 2002.
Dr Y V Reddy is grateful to Dr D V S Sastry, Shri Deepak Mohanty, Shri Indranil Bhattacharyya and Shri Kaushik
Bhattacharya for their assistance
* * *
Friends
It is a great honour to be asked to deliver an invited lecture at the annual conference of the Indian
Econometric Society and I am grateful to the organisers for this opportunity. For obvious reasons,
including the growing interest in monetary policy, I intend presenting before you the parameters of
monetary policy in India. In the first part of this lecture, I propose to give a general overview of the
parameters of monetary policy. In the second part, I would touch upon the international experience in
this regard with a particular focus on changing contours. The third part contains a description of
evolving parameters of monetary policy in India beginning with a brief description of the process of
policy making. The fourth part would highlight the impressive gains made dring the reform period so
far, in regard to statutory preemptions, deregulation of interest rates, financial and external stability
despite the persisting fiscal deficits and large market borrowing programmes. The concluding part sets
forth immediate tasks before the Reserve Bank of India in its conduct of monetary policy.
Parameters of Monetary Policy
Objectives
It is generally believed that central banks ideally should have a single overwhelming objective of price
stability. In practice, however, central banks are responsible for a number of objectives besides price
stability, such as currency stability, financial stability, growth in employment and income. The primary
objectives of central banks in many cases are legally and institutionally defined. However, all
objectives may not have been spelt out explicitly in the central bank legislation but may evolve through
traditions and tacit understanding between the government, the central bank and other major
institutions in an economy.
Of late, however, considerations of financial stability have assumed increasing importance in monetary
policy. The most serious economic downturns in the recent years appear to be generally associated
with financial instability. The important questions for policy in the context of financial instability are the
origin and the transmission of different types of shocks in the financial system, the nature and the
extent of feedback in policy and the effectiveness of different policy instruments.
Transmission Mechanism
Monetary policy is known to have both short and long-term effects. While it generally affects the real
sector with long and variable lags, monetary policy actions on financial markets, on the other hand,
usually have important short-run implications. Typical lags after which monetary policy decisions begin
to affect the real sector could vary across countries. It is, therefore, essential to understand the
transmission mechanism of monetary policy actions on financial markets, prices and output. Central
banks form their own views on the transmission mechanism based on empirical evidence, and their
monetary strategies and tactics are designed, based on these views. However, there could be
considerable uncertainties in the transmission channels depending on the stages of evolution of
financial markets and the nature of propagation of shocks to the system.
The four monetary transmission channels, which are of concern to policy makers are: the quantum
channel, especially relating to money supply and credit; the interest rate channel; the exchange rate
channel, and the asset prices channel. Monetary policy impulses under the quantum channel affect
the real output and price level directly through changes in either reserve money, money stock or credit
aggregates. The remaining channels are essentially indirect as the policy impulses affect real activities
through changes in either interest rates or the exchange rate or asset prices. Since none of the
channels of monetary transmission operate in isolation, considerable feedbacks and interactions, need
to be carefully analysed for a proper understanding of the transmission mechanism.
The exact delineation of monetary policy transmission channels becomes difficult in the wake of
uncertainties prevalent in the economic system, both in the sense of responsiveness of economic
agents to monetary policy signals on the one hand, and the proper assessment by the monetary
authority of the quantum and extent of desired policy measures on the other. The matter is particularly
complex in developing countries where the transmission mechanism of monetary policy is in a
constant process of evolution due to significant ongoing structural transformation of the economy.
Strategies and Tactics
It is important to distinguish strategic and tactical considerations in the conduct of monetary policy.
While monetary strategy aims at achieving final objectives, tactical considerations reflect the short run
operational procedures. Both strategies and tactics for monetary management are intricately linked to
the overall monetary policy framework of a central bank. Depending upon the domestic and
international macroeconomic developments, the long run strategic objective could change, leading to
a change in the nature and the extent of short run liquidity management.
The strategic aspects of monetary management crucially depend on the choice of a nominal anchor by
the central bank. In this regard, four broad classes of monetary strategies could be distinguished. Two
of these, viz., monetary targeting and exchange rate targeting strategies, use a monetary aggregate
and the exchange rate respectively as an explicit intermediate target. The third, viz., multiple indicator
approach, does not have an explicit intermediate target but is based on a wide range of monetary and
financial indicators. The fourth, viz., inflation targeting, also does not have an intermediate target, but
is characterized by an explicit final policy goal in terms of the rate of inflation.
In the 1970s when monetary policy came into prominence, many countries adopted either money
supply or exchange rate as intermediate targets. During the late 1980s, these paradigms started to
change following globalization, technological advancements and large movement of capital across
national boundaries.
In view of difficulties in conducting monetary policy with explicit intermediate targets, of late, some
countries are switching to direct inflation targeting, which works by explicitly announcing to the public
the goals for monetary policy and the underlying framework for its implementation. In this framework,
the monetary authorities have the freedom to deploy the instruments of monetary policy to the best of
their capacities, but are limited in their discretion of policy goals. The framework is advocated on the
ground that it clearly spells out the extent of central bank accountability and transparency.
In reality, monetary policy strategy of a central bank depends on a number of factors that are unique to
the country and the context. Given the policy objective, any good strategy depends on the
macroeconomic and the institutional structure of the economy. An important factor in this context is the
degree of openness of the economy. The more open an economy is, the more the external sector
plays a dominant role in monetary management. The second factor that plays a major role is the stage
of development of markets and institutions: with technological development as an essential ingredient.
In a developed economy, the markets are integrated and policy actions are quickly transmitted from
one sector to another. In such a situation, perhaps it is possible for the central bank to signal its
intention with one single instrument.
Operating Procedures
Operating procedures refer to the choice of the operational target, the nature, extent and the
frequency of different money market operations, the use and width of a corridor for market interest
rates and the manner of signaling policy intentions. The choice of the operating target is crucial as this
variable is at the beginning of the monetary transmission process. The operating target of a central
bank could be bank reserves, base money or a benchmark interest rate. While actions of a central
bank could influence all these variables, it should be evident that the final outcome is determined by
the combined actions of the market forces and the central bank.
The major challenge in day-to-day monetary management is decision on an appropriate level of the
operating target. The success in this direction could be achieved only if the nature and the extent of
interaction of the policy instruments with the operating target is stable and is known to the central
bank. As the operating target is also influenced by market movements, which on occasions could be
extremely volatile and unpredictable, success is not always guaranteed. Further, success is also
dependent on the stability of the relationship between the operating target and the intermediate target.
In a monetary targeting framework, this often boils down to the stability and the predictability of the
money multiplier. In an interest rate targeting framework, on the other hand, success depends upon
the strength of the relationship between the short-term and the long-term interest rates. Finally, the
stability of the relationship between the intermediate and the final target is critical to the successful
conduct of the operations.
Monetary Policy Transparency
Transparency in monetary policy is emphasised in the recent years on the ground that it leads to a
reduction in the market's uncertainty about the monetary authority's reaction function. It is further
argued that greater transparency may improve financial market's understanding of the conduct of
monetary policy and thus reduce uncertainty. The limits to transparency are also recognised since
publishing detailed results of a central bank's economic projections may eliminate an element of
surprise, which is useful on occasions with respect to the central bank's operations in financial
markets.
International Experience
In the conduct of monetary policy, although the experiences and the choices made by individual
countries vary, recent surveys highlight a number of common features, viz.,
• First, at the macro level, there is now widespread concern about the potential harmful effects
of persistently high fiscal deficits as it may lead to excessive monetisation.
• Second, there have been significant reductions in the reserve ratio to relieve the pressure on
the banking sector and reduce the costs of intermediation. In fact, a number of countries now
have no reserve requirement;. And, in some countries, the level of minimum deposit at the
central bank has fallen to such low levels that it is no longer considered an active monetary
instrument.
• Third, the deepening of financial markets and the growth of non-bank intermediation have
induced the central banks to increase the market orientation of their instruments. A
consequence of this is a greater activism of central banks in liquidity management.
• Fourth, the greater activism through indirect instruments led to a more intensive use of open
market operations (OMO) through flexible instruments like repo. The OMO can be used for
net injection or absorption of liquidity and can be resorted to irrespective of whether the
operating target works through the rate channel or quantity channel.
•
Fifth, the market environment has induced many central banks to focus more on the interest
rates rather than bank reserves in trying to influence liquidity.
• Sixth, increasing evidence of market integration implies that central banks can concentrate
on the very short end of the yield curve. There is growing evidence in favour of
comovements of interest rates of different maturity. This has simultaneously increased
monetary policy challenges, as central banks have to keep a watchful eye on all markets and
be cautious of any cascading effect or contagion emerging in the domestic economy or
originating in a foreign economy.
• Seventh, at an operational level, while there is increasing transparency on the long-run
strategic objective, central banks may not disclose their tactical considerations as some
maneuverability in influencing the market is required. However, in many cases information is
revealed to the market with a lag. Many central banks also attempt to estimate market
expectations directly through surveys. While market expectations play a major guidepost in
formulating monetary strategies, information management plays a crucial role for short-run
stabilisation.
• Eighth, a notable consequence of recent financial and currency crises has been the
increasing emphasis on the quantity and quality of data dissemination, i.e., adequate, timely
and reliable information in a standardized form.
• Ninth, a number of central banks now also disseminate the minutes of the meetings of major
monetary policy decisions, which help to gain credibility and in building a reputation of the
central bank in achieving the objectives of monetary policy.
• Tenth, an important issue is policy coordination between the fiscal and the monetary
authorities. The stance of fiscal policy is important as it has a much broader spectrum of
objectives. If fiscal authorities are the dominant players, monetary policy instruments are
rendered less effective. As monetary policy evolves from a transitional setting of fiscal
dominance, issues like direct access of government to central bank credit becomes
important and crucial for fiscal-monetary coordination.
• Eleventh, policy coordination is also an important issue facing economies linked by trade and
capital flows. In an increasingly synchronised business cycle environment, international
policy coordination becomes extremely important.
• Twelfth, internationally, there has been more awareness that policy effectiveness is
constrained by uncertainty. In fact, in many countries, the central bank projections are now
published in the form of a fan chart rather than point estimates.
Monetary Policy in India
Policy Making Process
Traditionally, the process of monetary policy in India had been largely internal with only the end
product of actions being made public. A process of openness was initiated by Governor Rangarajan
and has been widened, deepened and intensified by Governor Jalan. The process has become
relatively more articulate, consultative and participative with external orientation, while the internal
work processes have also been re-engineered to focus on technical analysis, coordination, horizontal
management, rapid responses and being market savvy.
The stance of monetary policy and the rationale are communicated to the public in a variety of ways,
the most important being the annual monetary policy statement of Governor Jalan in April and the
midterm review in October. The statements have become over time more analytical, at times introspective
and a lot more elaborate. Further, the statements include not only monetary policy stance or measures
but also institutional and structural aspects. The monetary measures are undertaken as and when the
circumstances warrant, but the rationale for such measures is given in the Press Release and also
statements made by Governor and Deputy Governors unless a deliberate decision is taken not to do
so on a contemporaneous basis. The sources for appreciating the policy stance encompass several
statutory and non-statutory publications, speeches and press releases. Of late, the RBI website has
become a very effective medium of communication and it is rated by experts as one of the best among
central bank websites in content, presentation and timeliness. The RBI's communications strategy and
provision of information have facilitated conduct of policy in an increasingly market-oriented
environment.
Several new institutional arrangements and work processes have been put in place to meet the needs
of policy making in a complex and fast changing world. At the apex of policy process is Governor,
assisted closely by Deputy Governors and guided by deliberations of a Board of Directors. A
Committee of the Board meets every week to review the monetary, economic, financial conditions and
advice or decide appropriately. Much of the data used by the Committee is available to the public with
about a week's lag. There are several other standing and adhoc committees or groups of the Board
and Board for Financial Supervision plays a critical role in regard to institutional developments.
Periodic consultations with academics, market participants and financial intermediaries take place
through Standing Committees and Ad Hoc Groups, in addition to mechanisms such as resource
management discussions with banks. Within the RBI, the supervisory data, market information,
economic and statistical analysis are reoriented to suit the changing needs. A Financial Markets
Committee focuses on a day-to-day market operations and tactics while a Monetary Policy Strategy
Group analyses strategies on an ongoing basis. Periodic consultations with the Government, mainly
with Ministry of Finance do ensure coordination. In brief, there are significant technical, analytical,
institutional and dynamic inputs that go into the process of making monetary policy.
Objectives
Although there has not been any explicit legislation for price stability, the major objectives of monetary
policy in India have been those of maintaining price stability and ensuring adequate flow of credit to
the productive sectors of the economy. The relative emphasis between the objectives depends on the
underlying economic conditions and is spelt out from time to time. Compared to many other
developing economies, India has been able to maintain a moderate level of inflation. Historically,
inflation rates in India rarely touched double digit and when they did, in most cases, they were the
result of supply shocks either in the form of increase in agricultural commodity prices or in the form of
increase in international prices of crude oil.
Transmission Mechanism
The monetary policy framework in India from the mid-1980s till 1997-98 can, by and large, be
characterized as a monetary targeting framework on the lines recommended by Chakravarty
Committee (1985). Because of the reasonable stability of the money demand function, the annual
growth in broad money (M3) was used as an intermediate target of monetary policy to achieve
monetary objectives. Monetary management involved working out a broad money growth through the
money demand function that would be consistent with projected GDP growth and a tolerable level of
inflation. In practice, however, the monetary targeting approach was used in a flexible manner with a
'feedback' from the developments in the real sector.
While the monetary system in India is still evolving and the various inter-sectoral linkages in the
economy are undergoing changes, the emerging evidences on transmission channel suggest that the
rate channels are gradually gaining importance over the quantum channel. The econometric evidence
produced by the Third Working Group on Money Supply (1998) indicated that output response to
policy operating through the interest rate was gaining strength. Similarly, the impact of an
expansionary monetary policy on inflation was found to be stronger through interest rates than the
exchange rate, given the relatively limited openness of the economy.
Strategies and Tactics
There has been a shift in strategic objective, necessitated by deregulation and liberalization of the
financial markets combined with increasing openness of the economy. The estimated income elasticity
of demand for money which had exhibited a clearly decreasing trend in the earlier part of the reform
period showed a sharp turning point in 1996-97 resulting in an increasing trend thereafter. The
changing nature of the relationship highlights that while money is still an important indicator,
information pertaining to other monetary and financial indicators should also be taken into account
seriously while formulating monetary policy, especially in view of the sweeping changes in the financial
sector in India in recent years. From the year 1998-99, RBI announced that henceforth it would follow
a multiple indicator approach. In this approach, interest rates or rates of return in different markets
along with movements in currency, credit, fiscal position, trade, capital flows, inflation rate, exchange
rate, refinancing and transactions in foreign exchange - available on high frequency basis - are
juxtaposed with output data for drawing policy perspectives. In a way, such a shift was a logical
outcome of measures taken over the reform period since the early 1990s.
Operating Procedures
In the pre reform period prior to 1991, given the command and control nature of the economy, the
Reserve Bank had to resort to direct instruments like interest rate regulations, selective credit control
and the cash reserve ratio (CRR) as major monetary instruments. These instruments were used
intermittently to neutralize the monetary impact of the Government's budgetary operations.
The administered interest rate regime during the earlier period kept the yield rate of the government
securities artificially low. The demand for them was created through intermittent hikes in the Statutory
Liquidity Ratio (SLR). The task before the Reserve Bank of India was, therefore, to develop the
markets to prepare the ground for indirect operations.
As a first step, yields on government securities were made market related. At the same time, the RBI
helped create an array of other market related financial products. At the next stage, the interest rate
structure was simultaneously rationalized and banks were given the freedom to determine their major
rates. As a result of these developments, RBI could use OMO as an effective instrument for liquidity
management including to curb short-term volatilities in the foreign exchange market.
Another important and significant change introduced during the period is the reactivation of the Bank
Rate by initially linking it to all other rates including the Reserve Bank's refinance rates (April 1997).
The subsequent introduction of fixed rate repo (December 1997) helped in creating an informal
corridor in the money market, with the repo rate as floor and the Bank Rate as the ceiling. The use of
these two instruments in conjunction with OMO enabled RBI to keep the call rate within this informal
corridor for most of the time. Subsequently, the introduction of Liquidity Adjustment Facility (LAF) from
June 2000 enabled the modulation of liquidity conditions on a daily basis and also short term interest
rates through the LAF window, while signaling the stance of policy through changes in the Bank Rate.
Gains from Reform
It has been possible to reduce the statutory preemption on the banking system. The Cash reserve
Ratio (CRR), which was the primary instrument of monetary policy, has been brought down from
15.0 per cent in March 1991 to 5.5 per cent by December 2001. The medium-term objective is to bring
down the CRR to its statutory minimum level of 3.0 per cent within a short period of time. Similarly,
Statutory Liquidity Ratio (SLR) has been brought down from 38.5 per cent to its statutory minimum of
25.0 per cent by October 1997.
It has also been possible to deregulate and rationalise the interest rate structure. Except savings
deposit, all other interest rate restrictions have been done away with and banks have been given full
operational flexibility in determining their deposit and lending rates barring some restrictions on export
credit and small borrowings. The commercial lending rates for prime borrowers of banks has fallen
from a high of about 16.5 per cent in March 1991 to around 10.0 per cent by December 2001.
In terms of monetary policy signals, while the Bank Rate was dormant and seldom used in 1991, it has
been made operationally effective from 1997 and continues to remain the principal signaling
instrument. The Bank Rate has been brought down from 12.0 per cent in April 1997 to 6.5 per cent by
December 2001. It is envisaged that the LAF rate would operate around the Bank Rate, with a flexible
corridor, as more active operative instrument for day-to-day liquidity management and steering
shortterm interest rates.
A contrasting feature in the positions between 1991 and 2001 is India's foreign exchange reserves.
The monetary and credit policy for 1991-92 was formulated against the background of a difficult
foreign exchange situation. Over the period, external debt has been contained and short-term debt
severely restricted, while reserves have been built in an atmosphere of liberalisation of both current
account and to some extent capital account.
The foreign currency assets of the Reserve Bank have increased from US $ 5.8 billion in March 1991
to US $ 48.0 billion in December 2001. In view of comfortable foreign exchange reserves, periodic oil
price increases (for example in 1996-97, 1999-2000 and 2000-01) did not translate into Balance of
Payment (BoP) crises as in the earlier occasions. Such enlargement of the foreign currency assets, on
the other hand, completely altered the balance sheet of the Reserve Bank.
Large capital inflows have been accommodated by the Reserve Bank while its monetary impact has
been sterilized through OMO. This has helped in reducing the government's reliance on credit from
RBI. Consequently, there has been secular decline in monetised deficit, and in the process net foreign
exchange assets of RBI have become the principal contributor to reserve money expansion in the
recent period.
Tasks before RBI
These are impressive gains from reform but there are emerging challenges to the conduct of monetary
policy in our country. Thus, while the twin objectives of monetary policy of maintaining price stability
and ensuring availability of adequate credit to the productive sectors of the economy have remained
unchanged, capital flows and liberalization of financial markets have increased the potential risks of
institutions, thus bringing the issue of financial stability to the fore. Credit flow to agriculture and small-
and medium-industry appears to be constrained causing concerns. There are significant structural and
procedural bottlenecks in the existing institutional set up for credit delivery. The pace of reforms in real
sector, particularly in property rights and agriculture also impinge on the flow of credit in a deregulated
environment. The persistence of fiscal deficit, with the combined deficit of the Central and State
Governments continuing to be high, draws attention to the delicate internal and external balance.
It is necessary to recognize the existence of the large informal sector, the limited reach of financial
markets relative to the growing sectors, especially services, and the overhang of institutional structure
that tend to constrain the effectiveness of monetary policy in India. The road ahead would be
demanding and the Reserve Bank would have to strive to meet the challenge of steering the
structurally transforming economy from a transitional phase to a mature and vibrant system and
increasingly deal with alternative phases of the business cycle. Some of the immediate tasks before
RBI are presented to provoke debate and promote research.
Modeling Exercises
In addressing a gathering of elite econometricians assembled here, a mention should be made about
developments in monetary modeling. It is well recognized that monetary policy decisions must be
based on some idea of how decisions will affect the real world and this implies conduct of policy within
the framework of a model. As Dr. William White of Bank for International Settlements (BIS) mentioned
in an address recently in RBI, "the model may be as simple as one unspecified equation kept in the
head of the central bank Governor, but one must begin somewhere. Economics may not be a science,
but it should at least be conducted according to scientific principles recognizing cause and effect".
While reliance on explicit modeling was rather heavy in some central banks, particularly in the 1960
and 1970s, there has been increasing awareness among the policy markers of the limitations of such
models for several reasons. It is difficult to arrive at a proper model for any economy with the degree
of certainty that policy makers want especially in view of observed alterations in the private sector
behaviour in response to official behaviour. Further, data to monitor the economy are sometimes
inadequate, or delayed, and often revised. It is said that in regard to modern economies, not only the
future but even the past is uncertain, due to significant revisions in data. The process of deregulation
coupled with technological progress has led to increasing role for market prices and consequently
more complexities for establishing relationships in an environment where everything happens very
fast, and in a globally interrelated financial world. In brief, there is need to recognize the complexities
in model building for monetary policies and approach it with great humility and a dose of skepticism
but ample justification for such modeling work certainly persists.
It is felt that this is an appropriate time to explore more formally the relationship among different
segments of the markets and sectors of the economy, which will help in understanding the
transmission mechanism of the monetary policy in India. With this objective in mind, RBI had already
announced its intention to build an operational model, which will help the policy decision process. An
Advisory Group with eminent academicians like Professors Mihir Rakshit, Dilip Nachane, Manohar
Rao, Vikas Chitre and Indira Rajaraman as external experts and a team from within the RBI were set
up for developing such a model.
The model was initially conceived to focus on the short term objective of different sources and
components of the reserve money based on the recommendations of an internal technical group on
Liquidity Analysis and Forecasting. Though, multi-sector macro econometric models are available,
such models are based on yearly data and hence these may not be very useful for guiding the short
term monetary policy actions of RBI. Accordingly, it was felt that a short- term liquidity model may be
developed in the RBI focusing on the inter-linkages in the markets and then operationalise these
linkages to other sectors of the economy. The Advisory Group met twice and after deliberations felt
that a daily/weekly/fortnightly model would give an idea about short- to medium-term movements but
models using annual data will also be useful to assess the implications of the monetary policy
measures on the real economy. On the basis of the advice of eminent experts in the Advisory Group, it
has been decided to modify the approach.
The current thinking in RBI is broadly on the following lines: the short term liquidity model making use
of high frequency data will be explored. Accordingly, the interaction of the financial markets with
monetary policy have been examined with weekly data focusing mainly on policy measures and
different rates in the financial markets. Observations in the operational framework of the model is
limited as the LAF has been operationalised only a year ago. A crucial aspect in an exercise is the
forecast of currency in circulation.
The intention of RBI is to expedite the technical work in this regard and seek the advice of individual
members of Advisory Group on an ongoing basis both at formal and informal levels. It is expected that
the draft of the proposed model would be put in public domain shortly. RBI would seek the active
participation of the interested econometricians in the debate on the draft model and give benefit of
advice to RBI for finalizing and adoption.
Reduction in CRR
Among the unrealized medium-term objectives of reforms in monetary policy, the most important is
reduction in the prescribed CRR for banks to its statutory minimum of 3.0 per cent. The movement to
3.0 per cent can be designed in three possible ways, viz., the traditional way of pre-announcing a
time-table for reduction in the CRR; reducing CRR as and when opportunities arise as is being done in
recent years; and as a one-time reduction from the existing level to 3.0 per cent under a package of
measures.
In the initial