Y V Reddy: The virtues and vices of talking about monetary policy -
some comments
Remarks by Dr Y V Reddy, Governor of the Reserve Bank of India, at the 7th BIS Annual
Conference, Luzern, Switzerland, 26 June 2008.
* * *
Governor Yilmaz, Professor Alan Blinder, Professor Benjamin Friedman, fellow-Governors,
and distinguished academics,
I am honoured by the invitation from the Bank for International Settlements to be a
discussant, for a Paper1 by the eminent and respected scholar, Professor Alan Blinder. It is
virtually impossible to add value to the comprehensive and incisive analysis of the subject in
the Paper, which is on a subject of great relevance to central bankers. My comments will be
basically to supplement or elaborate some ideas in the Paper, from a practitioner's point of
view. To begin with, there will be select comments on each of the sections of the Paper
keeping in view the Indian perspectives. The second part will highlight select issues, which
appear to be especially relevant to monetary policy communication in emerging market
economies (EMEs). The concluding part will pose some issues, which deserve debate in the
search for what Professor Blinder calls "optimal" central bank communications policies.
Indian perspectives
Reasons for communication
There has been significant progress in India in enhancing communication and removing the
mystique surrounding monetary policy. While in the pre-reform period, before the 1990s, the
communication was relatively easy in a controlled environment, it has become a greater
challenge in a market oriented environment particularly in the context of global financial
market integration. The stake holders have become larger and wider and the monetary policy
by itself in terms of operating framework and instruments has assumed increasing
complexity. There is a clear recognition of the importance of market expectations in the
conduct of monetary policy, partly influenced by academic work and partly by the
demonstration effect of evolving practices among central banks. Perhaps, there are also
other reasons for the demand for such enhanced communications in India; for example,
increasingly greater transparency is demanded, as part of public policy, in almost all spheres
of governance of the public sector, which includes the central bank. The media - we have six
business dailies in English, apart from four business channels on television - exerts
pressure, seeking information on many issues. In a way, there is both a supply side and a
demand side to the communications by the Reserve Bank of India (RBI) on monetary policy
aspects, in the context of evolving market expectations.
On the need for communications, we have no doubt that it enhances the effectiveness of
monetary policy in a liberalized market environment. In fact, the experience in India shows
that the need to communicate, by itself, compels far more rigorous thinking and analyses, as
it is said that the best of learning comes from a compulsion to teach. The compulsions to
communicate catalyse the processes to improve the quality of decision making and by
providing a helpful feedback.
Democratic accountability, as a reason for better communication, is very valid for India also.
But, improvements in communication have been taking place in the recent years without any
formal recognition of the extent of RBI's independence. My personal feeling is that improved
communication in regard to the thinking and the actions of the RBI has enhanced the de
facto central bank independence while, de jure, there has been no noticeable movement in
according greater independence.
Accountability to Parliament, the supreme body of elected representatives, is very important
in the context of the functioning of a central bank in a democracy. In India, the RBI is
accountable to the Parliament through the Ministry of Finance and thus its communication to
the Parliament is through the Ministry. Whenever the views between the central bank and the
Ministry converge, there should be no complexities. RBI is also summoned to give evidence
before Parliamentary Committees, most often along with the officials of the Ministry of
Finance. There are some occasions when the hearings of the committees are restricted to
the RBI, generally when the Governor is called in. However, we are sworn to secrecy from
making public our submissions to the Parliamentary committees, whereas the committee
may make use of the material supplied by us, as considered appropriate. In a sense, the
RBI's views, as submitted to the Parliamentary Committees, are not available in their entirety
in the public domain.
It is quite possible that there are communications or signals, if not directions, from the
Ministry of Finance often on issues relating to monetary policy or banking, a sector
predominantly government owned. If these are consistent with those of the central bank, they
reinforce the central bank policies, but if these are divergent, it poses a dilemma for central
bank communication and to that extent a central bank may be constrained in freely
articulating its policies.
These are some noteworthy features of communication in the context of democratic
accountability to the Parliament in India.
Limits to communication
Based on my personal experience, it is possible to mention some limitations to making
communication more effective in India. Most often, in any given context, the preferences of
market participants may be different but not necessarily opposed to the public policy
preferences. While transparency and communication in such circumstances helped in a
reordering of the preferences, a surprise element in the decisions and timing of the
communication was more effective when the public policy preferences and the market
preferences were in virtually opposite directions. In the latter case, the communication of the
reasoning for the actions, either concurrently or ex post, was found to be desirable.
Communication is not pre-commitment
Pre-commitment is generally useful on many occasions as part of monetary policy
communication. I have two observations based on our experience in this regard. First, in
highly uncertain conditions, a conscious view needs to be taken on the virtues of
precommitment. Second, even when there is a pre-commitment and some reversal was needed
at some stage due to unforeseen circumstances, a detailed and timely explanation for
deviating from the assurance helps clarifying the situation. Further, degrees of
precommitment may vary from a "vague but indicative" to "a definitive time-table", and our
choice has varied depending on the circumstances.
What to communicate
On what to communicate, Professor Blinder refers to four different aspects of monetary
policy; namely, overall objectives and strategy, motives behind a particular decision, the
economic outlook and future monetary policy decisions. Most difficulties in putting these into
practice arise in regard to the future monetary policy decisions. Our effort in this regard has
been to explain the stance of the monetary policy that would govern the future, which is done
currently at quarterly intervals. The emphasis of this communication is on presenting
information and analyses, that allows the market participants to draw their own inferences,
but the RBI desists from giving any explicit forward guidance.
The RBI is not only responsible for monetary policy but also for banking regulation, and for
management of the external sector and the government debt. Further, the content of
communications relates not only to policy changes but also to the path of structural reforms,
including legal reforms. In our periodical communications we have adopted a format of
presenting the monetary policy and developmental and regulatory policies in two distinct
sections in our annual and mid-term reviews; while the first quarter and the third quarter
communications are confined to monetary policy. Cross-references are no doubt, inevitable.
These are in addition to various other forms of communication - regular or ad hoc, and
formal or informal.
Central bank communication is generally perceived as synonymous with pronouncements on
monetary policy. In fact, a central bank's dilemma is more pronounced with regard to
communication of supervisory issues. On supervisory matters, the central bank
communicates to the common person and does not confine necessarily to a specialized
audience like financial markets or financial institutions. These market players with knowledge
and skills can absorb such communication in the right spirit though they may have specific
business interests. What the general public desires to know may at times be at a variance
from what the market players would like to be disclosed. The dilemmas of a supervisor,
especially in a country like India are even more complex on account of the level of financial
education.
Strategies and content of communication may have to be different for meeting the challenges
to financial stability as compared to maintaining price-stability. In India, several measures,
monetary as well as administrative, were undertaken to meet the threats to financial stability
while complementary or parallel recourse was taken to communications. Some illustrations
are: a speech in Goa in August 1997 to "talk down the rupee"; reassuring statements on
market developments in the context of Asian crisis combined with a package of measures, in
tranches in 1997 and 1998; pre-emptive measures in mid-1998 in the context of crisis in
Russia; reassuring statements issued in the context of border conflict in 1999; a combination
of liquidity injection and reassuring statements along with measures in the context of the
9/11; and in 2005, to explain the impact of the redemption of the India Millennium Deposits,
to the extent of US dollar seven billion, on the foreign exchange markets. There could also
be occasions where the central bank may not react to certain instances, for example when
some sanctions were imposed on India. But, these decisions are taken thoughtfully and
consciously after duly taking into account the need and market sensitivity. In brief, we take
recourse to open market operations, open mouth operations, and open only eyes and ears
operations in regard to threats to financial stability.
How to communicate
The public-face of the RBI in regard to formal communications is the Governor, but the
Deputy Governor who deals with the subject also interacts more actively, more frequently
and in greater depth with the media. These are in addition to the legal reporting requirements
and several other documents that are placed in public domain at periodical intervals. In the
absence of a formally constituted Monetary Policy Committee, this arrangement works well in
terms of communicating with coherence, clarity and credibility.
On the impact of RBI's communication on financial markets, the most notable contribution
has been in generating a better understanding, debates and sensitivities among the market
participants and analysts, of the issues involved in money, finance and macro-stability. This
process has been critical for India partly because the legacy of a planned economy required
un-learning as well as re-learning and partly because the financial sector reform process as
well as the context has been somewhat more unique to India than in many other EMEs.
Predictability
On the predictability of the monetary policy decision in India, I am not aware of any research
work on the subject. Let me therefore take recourse to anecdotal evidence. Since 2004, RBI
has been withdrawing monetary accommodation, strengthening prudential requirements and
emphasizing risks to price as well as financial stability. Most market participants seemed to
have conditioned, at least until recently, their expectations of monetary policy response on
what they considered to be the standard practice in advanced economies. As a result, for
some time in the past, the RBI acquired an unwarranted reputation of always surprising the
markets, prompting me to quip at one stage that "the financial markets always surprise me
with their expectations from the RBI".
As regards the forms of central bank communications, our experience is that formal,
structured and periodic statements are normally valued significantly, but there is a markedly
heightened interest in speeches and comments in times of unexpected global or domestic
developments.
India is not an inflation-targeting country. The democratic pressures have proved to be a
disciplining force so far, and its record over five decades is reasonable relative to most
developing countries. Further, the two groups of commodities that carry a large weight in the
consumption basket, namely food and fuel, are subject to supply shocks, making it difficult to
identify a "core" that could be meaningfully targeted. Yet, there are suggestions, mainly from
the academia, for inflation targeting but there is little or no support for it in political economy.
There is a reference in the Paper to paying some attention to communication with the
general public. In India, we recognize that communication is not neutral to the target
audience. The RBI communicates with various types of audiences - researchers, analysts,
academicians, media persons, entities regulated by the central bank, other central bankers,
rating agencies, international or multi-lateral bodies, and players in the financial markets. The
RBI also endeavours to communicate with other special audiences, such as, urban and rural
women and men, senior citizens, defence personnel and even school children. Let me
illustrate with a communication initiative that RBI has undertaken two years ago. The
Ombudsman Scheme for banks was revised recently and hence, the objective was to inform
the widest section of our population. A Press Release might not have fully served the
purpose. So, a decision was taken to issue an advertisement in print media - for which the
content was indeed common but the languages differed. It was interesting to note that while
the 15 leading Hindi newspapers with a larger circulation at 8.1 million and a far larger
readership at 87.0 million helped us reach an audience that was almost five times larger than
what we could have reached if we had advertised in leading English newspapers which are
17 and have a combined circulation of 6.3 million and readership of 17.9 million. In fact, in
India, 54 leading non-English newspapers have a circulation of 21.4 million and a readership
of 197.2 million. Given this experience of ours, we made the RBI website available apart from
in English and Hindi, which are official languages of the Union Government, in 11 other
national languages spoken by a large section of the population. Further, the RBI last year
launched a Financial Literacy Project to educate the common person who is generally not
financially literate. The project aims at imparting information and knowledge about banking,
finance, and central banking to the common person in her' or his own language. The material
published under this project is, therefore, also made available in 11 major Indian languages
apart from English and Hindi through a multi-lingual website.
These illustrations fully endorse what Professor Blinder has said in his Paper "In the end,
central banks derive their democratic legitimacy and hence their cherished independence
from the consent of the general public"
Select issues relevant to EMEs
Let me attempt a few generalizations on the subject, keeping in view the EME perspectives.
First, it is not very clear whether the empirical research on the subject referred in Professor
Blinder's paper has adequately covered EMEs. For example, BRIC countries (Brazil, Russia,
India and China), South Africa, Indonesia, Saudi Arabia etc., are emerging as significant
players in the global economy. Are their experiences different from those researched so far?
Second, the government happens to be a significant player in many EMEs, especially in the
financial sector. In the circumstances, should communication with financial markets, which
should admittedly be two-way for optimal results, exclude communication by/ with the
government? Naturally communication by/with the government, by its very nature, will have a
differential and, at times, overlapping impact. But how does it affect the independence of the
central bank and its policy effectiveness? This dimension poses a challenge for
communication policy.
Third, the education function of central bank communication, that Professor Blinder referred
to, may be more important in EMEs. In fact, such a function may enlarge the role of a central
bank in the EMEs, when it carries credibility. In this regard, let me quote from an undelivered
speech of a distinguished central banker2 on the subject.
"Communication is not just about transparency. It is also about education,
guidance and steering things in the right direction. In this, the central bank
can be an honest broker between the government and the public and even
the parliament."
In fact, a central bank can influence changes in public policy that are relevant to monetary
and financial policies. For example, at the cost of modesty, let me quote Mr. Tarapore, a
respected central banker.
"... when the definitive history of India's policy on gold is written up, the
speech by Dr. Y. V. Reddy, Deputy Governor, Reserve Bank of India, at the
World Gold Council Conference on 28 November 1996 will stand out as a
watershed as it is perhaps the only speech by a senior Indian official which
squarely takes on issues on gold policy and it will be appropriately recorded
as a forerunner of major policy change".3
Fourth, relative to many other institutions in the public sector, central banks in many EMEs
happen to have professional skills, experience and objective and independent thinking which
can be drawn upon by the government, especially during the process of reform, in particular
reforms in the financial sector. Structural changes involving institutional and legal changes in
EMEs may need active inputs from the respective central banks. How do theory, practice and
expectation of a transparent and independent central bank reconcile with these practical
compulsions?
Fifth, the issue of financial stability is of great significance and enormous complexity for
central bankers in the EMEs. These economies vary considerably with regard to their fiscal,
current account, openness to external sector, and dependence on oil-earnings or oil-imports.
Yet, the analysts in the financial markets often treat them as a group, presumably because
the EMEs are perceived to be high-risk and high-reward destinations for financial capital.
That characteristic makes them more vulnerable to volatility in capital flows, sometimes for
reasons other than economic fundamentals in the country concerned. As the title implies, the
EMEs are emerging from one state to another, namely, from less market orientation to
greater market orientation, and are thus, in a state of transition. Consequently, the central
banks in the EMEs, in their pursuit of financial stability, have additional challenges. First, to
manage the transition in their own economies, which has socio-economic as well as political
dimensions; second, to keep a watch on the sentiments affecting foreign capital flows -
which could change for reasons other than domestic.
The challenges for communication policy are considerably more complex for the central
banks in the EMEs for some other reasons. More generally the style and content of
communication in EMEs has to evolve over time consistent with progress in financial
sophistication. Further, in a globalised world, the communications by a central bank in
advanced economies have a great impact on financial markets in EMEs. Communications,
including scope for pre-commitment in policy, may have to factor-in these complexities.
Some issues for debate
Before concluding, I should admit that Professor Blinder's Paper has provoked some
thoughts that warrant further debate and I will mention them briefly.
First, communication is a two-way process and it is all about sharing of information. Market
functionaries and agents have an equal role in enhancing their disclosure of data and
information. But, studies seem to focus on one-sided communication from the policy makers.
How far non-transparent and asymmetric markets could adversely affect the policy
effectiveness of central banks? The recent sub-prime turmoil is a clear case in point. This
may be worth examining.
Second, while discussing independence of central banks how do we capture the de facto
elements as distinct from the de jure elements? While it is true that the distinction is specific
to the overall governance in public sector in each country, there may be an explanation for
divergences between the two that may either reinforce or undermine the credibility of
communication. Further, there may be different degrees of independence that are being
exercised in practice and it might be interesting to try and understand how these could be
captured in future studies.
Third, the exercise of independence has generally been discussed in the context of price
stability. The issue becomes more complex when threats to financial stability are faced, since
crisis management, as distinct from prevention, requires coordination or at least consultation
with the government, both in terms of actions and communication. This is particularly
relevant if quasi-fiscal costs are involved. The more complex issue of managing the conflicts
between price and financial stability goals on some rare occasions warranting consultation or
coordination with the government, is another issue.
Fourth, how much of the recent empirical evidence is adequate to give credit to effectiveness
of monetary policy by central banks relative to say, globalization of trade in goods and
services? At this stage, I must share with you one concern about the credibility bonus earned
by an effective communication policy that I had expressed in 2006.
"Is it possible that such "hands on" and "very successful" communication by
many central banks with regard to maintaining financial stability have
resulted in under-pricing of risks by the private sector, or in a distinct
lowering of aversion to financial risks? Is it possible that this credibility
bonus is partly responsible for the upward pressure on the housing and
equity prices becoming a global phenomenon?"4
Fifth, is it possible to envisage intermediate arrangements between an individualistic and a
mandated Monetary Policy Committee? We may have an example of such an intermediate
arrangement in India. We have an Advisory Committee on Monetary Policy, consisting of
Members drawn from non-executive independent Members of the RBI Board and outside
experts, to aid the decision making process. This arrangement enables participation without
diluting the coherence, credibility and the flexibility - especially in regard to communication.
Professor Blinder, in a paper on 12th December 20055, referred to four prototypical central
bank decision making systems namely: individual central bank governor (e.g. Reserve Bank
of New Zealand); autocratically-collegial MPC (e.g. Federal Reserve System);
genuinelycollegial MPC (e.g. European System of Central Banks); and individualistic MPC (e.g. Bank
of England). Perhaps India would be a fifth prototype placed somewhere in the middle of the
above four, in terms of proximity to the classic decision maker of economic theory. It could be
called individual central bank governor - voluntarily collegial (Reserve Bank of India).
Finally, in the debate on accountability and independence, it may be useful to be clear as to
whom the central bank is primarily accountable to. If a central bank does not enjoy
independence, the question of its direct accountability will not arise. Broadly speaking
however, do central banks tend to focus of late, more on accountability to financial markets,
by design or by necessity, rather than say to the government, or the real sector, or the public
at large?
Thank you.