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Tuesday, May 01, 2007

Confused about monetary policy

In recent weeks, monetary policy in India has faced many problems. Every plausible monetary policy regime ends up stabilising something - inflation, or interest rates, or exchange rates. You can disagree with what is being stabilised, but atleast something is. In recent weeks, India has suffered from huge volatility in all three. These suggest that the monetary policy regime is in distress. (See my blog entry from 7 March.)

In recent months, huge purchases of foreign currency were incompletely sterilised, fueling local inflation. These choices by RBI showed that the reaction function of RBI valued exchange rate policy over controlling inflation, even though the public rhetoric was full of talk about inflation. In mid-March, RBI appears to have stopped trading on the currency market. The INR appreciated sharply.

But there are numerous un-answered questions. Has the currency regime changed? What is the stance of monetary policy? Unfortunately, there are many uncertainties. The actions of RBI are the major risk factor that shapes future uncertainty. But it is not clear what RBI will do. The market does not know the monetary policy regime; it doesn't know the reaction function of RBI.

With this breakdown of the monetary policy framework, the recent credit policy statement would have been an ideal time for an introspective RBI to have displayed thought leadership, and offered a positive message of change. If such thinking is taking place, it is certainly not being communicated. RBI says that nothing was ever wrong and nothing needs to change. As an example:

q: Is there a need for the currency management policy to be changed as far as monetary management is concerned?

a: The exchange rate policy has served us very well in the last so many years and the exchange rate has been commended all around.

It has served the purpose of growth, stability, and external sector balance and there is no need to change any element of the exchange rate policy.

RBI believes that inflation targeting hasn't worked in the UK:

"Experience shows that inflation targeting has not worked in countries which had set formal inflation targets," Reserve Bank Governor YV Reddy said here.

Citing the example of the UK, he said that country had an open capital account, a pure monetary authority and an exchange rate which was virtually free, yet it had not succeeded in inflation targeting.

And, RBI seems to believe that an INR appreciation won't generate a negative impact on local prices:

Reserve Bank of India (RBI) governor Y V Reddy today disputed the notion that there is an inverse relation between the movement of the rupee and the direction of prices. The rupees rise to nine-year highs will not necessarily bring inflation down, he pointed out.

These unfortunate statements generate a loss of credibility and leave the market highly confused. Just in case you felt that RBI's retreat from currency trading in mid-March signified a change in the monetary policy regime, RBI is atleast saying this is not the case. Market manipulation of the currency market has gone down - does this mean we are headed for a more floating rate? But no, RBI recently bumped up the limit on MSS - so are we in for a bit more currency trading? (Isn't it time for MOF to question MSS?) Nobody knows what the next steps of monetary policy will be.

Business Standard had a fascinating edit titled Confusing signals on the subject on 30 April:

Has the Reserve Bank of India (RBI) changed its mind onand its attitude tocapital flows, currency management and how to cope with the problems caused by its established monetary policy? That would certainly seem to be the case, given the sharp rise of the rupee against the dollar in recent weeks. Perhaps the continuing strength of the capital inflow made it impossible for the RBI to continue with the old policy of trying to keep the rupee down by buying dollars and then sterilising the rupee funds that were generated by this action so that inflation did not get out of hand. Inflation was refusing to come under control, the dollar inflow was intensifying and monetary policy was coming unstuckwith higher interest rates causing their own problems. A change of tack may therefore have become inevitable.

From November 2006 to February 2007, the Reserve Bank of India spent Rs 88,000 crore to buy $19.7 billion on the currency market. These purchases are now worth about Rs 80,000 crore today, so the fall of the dollar has meant a substantial loss. An interest cost of 7 per cent, applied on Rs 80,000 crore worth of securities issued to sterilise rupee funds, would mean a further outflow of Rs 5,600 crore a year. Those are big numbers: Rs 14,000 crore would build a national highway from Delhi to Kanyakumari. But the true costs of the RBIs currency policy are even bigger. If dollar assets in November were $100 billion, a 10 per cent currency appreciation imposes a fiscal cost of 1 per cent of GDP. On top of that, there are costs owing to the poor returns on the reserves portfolio. The biggest cost of the policy, however, is not fiscal but political. Only a partial sterilisation of the dollar inflow was possible. As a result, in 2006-07, reserve money grew at 24 per cent, in contrast to 17 per cent in the previous year, resulting in higher inflation, which is politically unacceptable.

A higher external value for the rupee, which results from allowing the dollars to flow in and the RBI choosing not to intervene, is not without costs; the export slowdown that is already visible is one result. That is what has now made proponents of an activist currency policy unhappy, mindful as they are of what an export slowdown can mean to GDP growth and other macro-variables. The question is whether the RBI had a choice. Certainly, Y V Reddy, the RBI governor, seems to be singing a new tune after abandoning the erstwhile currency policy. With rising interest rates, inflation rates and money supply, the problems of monetary policy in India are visible to all. The question is whether a critical switch has been made in recent weeks, from the policies which worked fine in a closed economy, to a different policy matrix more in tune with an economy that is integrating with the rest of the world. The RBI does not make clear whether this is the case, and certainly its policy pronouncements should be different if it has indeed changed tack.

The centrepiece of a monetary policy statement is the central banks forecast of future inflation, which should guide interest rate setting today. Last weeks policy statement desires inflation of 4-4.5 per cent, but does not offer a path to that destination. While the stock market has been ecstatic because interest rates have not been jacked up again, the underlying problems remain. The government will want consumer price inflation to be no more than 3 per cent by 2008-09, so it is possible that the RBI may have to surprise markets again.

On the same day, Abheek Barua said:

Whatever the RBIs decision, it is imperative at this stage to communicate this to the markets if it is to put an end to the flux that currently prevails. If indeed, we are on the cusp of structural change in monetary management, the markets need to prepare for it. Second, if a less interventionist structure is indeed a short-term objective, the RBI has to recognise the imperfections and asymmetries in market structure that currently exist. These imperfections make a section of the banking system more vulnerable to the enhanced volatility that comes with a freer regime. Until the financial system moves to a new equilibrium, the central bank could perhaps provide these banks some succour.

What is to be done? The ideal thing is to have a consistent monetary policy regime. E.g. in the UK or the US, economic agents are not puzzled by the central bank; monetary policy decisions are not a source of risk. Even if a proper monetary policy regime is not in place, Ila Patnaik points out that a lot more transparency will help economic agents decipher what RBI is doing. Intuitively, think that economic agents, when armed with enough information, will run the right regressions and figure out what monetary policy is doing - regardless of what the central bank says.

I find that foreign banks or foreign financial firms often strongly advocate currency management by RBI. A pegged exchange rate, after all, is a gift of free risk management services for them. In addition, there are the great opportunities to make money from one-way bets, either speculative attacks or reverse speculative attacks. I find it fascinating to look back at how the people who saw the one-way bet on the INR a while ago have come out right.

Benn Steil and Robert Litan [book] have been preaching that third world countries lack the institutional capacity to do inflation targeting, and should just dollarise. At times like this, it's something to think of.


  1. Great article!!!
    but inflation targeting isn't the be all end all of monetary BoE is finding out
    This is especially true in India with headline inflation far from the "true" measure of inflation

  2. moreover, narrow inflation targeting (or dollarization, for the matter) can lead to asset price booms (or busts) that pose systemic risks to the economy

  3. Problems of targeting inflation in the UK - any RBI governor would LOVE to have these problems. The problems that we face are n times worse.

  4. While there may be merits for inflation targeting in advanced industrial countries (US, UK, EU), in my opinion, India is not ready for narrow and explicitly defined inflation targets for the following reasons.

    1. Measurement: The problems with WPI as a measure of inflation in India are well known. Most of the components in the WPI (Food articles, Food products, Fruit & vegetables, Milk, Oilseeds) are influenced by seasonal factors. Holding RBI accountable to a narrowly defined WPI target would lead to seasonal factors dominating underlying inflationary trends while setting inflation rates. Deficient rainfall in certain regions will increase headline inflation numbers without affecting underlying trends, leading the RBI to increase interest rates precisely when counter-cyclical policy may required. On the other hand, abundant rainfall would boost output and lower WPI, leading RBI to decrease interest rates when perhaps they should have been increased. RBI will be forced to follow pro-cyclical monetary policy instead of a counter-cyclical one.
    2. It is as good as impossible for the RBI and the CSO to come up with a stripped measure of inflation (like core inflation in the US) that reflects the consumption basket of the average Indian household, since expenditure on foodstuffs constitute a large part of most Indian household budget.
    3. The credibility of the RBI is as good as non-existent. It is hard to imagine that the financial markets will believe that the RBI will stick to the inflation targets, especially since it does not have legal independence. If setting explicit inflation targets does not increase central banks credibility, why bother. There may be better ways to do that in the Indian context.
    4. The government of the day (especially those who believe in 10% growth as India’s divine right) will engage in expansionary fiscal policy to counter a tight monetary policy. The FRBM Act won’t stop the government to engage in off balance sheet expenditures (such as oil bonds or using foreign exchange reserves for infrastructure) to boost growth, further fueling inflation. If the RBI refuses to monetize the expansionary fiscal policy, the government can force public sector banks or EPFO to step in. Persistent contractionary monetary policy many even lead to the central government going back on some of the fiscal reforms and push implementation of FRBM Act forward.
    5. Inflation and inflation expectations in India have been the result of supply shocks (rather than demand shocks). Given the weak mechanisms of transmission of monetary policy, it will be difficult for the RBI to control inflation in the short run without hurting the real sector. With strict inflation targets (and the pay of the RBI governor linked to the inflation targets being achieved), more often than not, the RBI will raise interest rates more than necessary chocking growth.
    6. For better or worse, the RBI controls the exchange rate. Floating the rupee, as would be required for inflation targeting, would certainly be desirable in the medium term but not in the short term. A high degree of volatility will certainly not suit India’s growth prospects at this critical juncture.

    Yes, inflation targeting should be a medium term goal but the institutional deficits of the RBI, lack of good high frequency data and the presence of a large number of households engaged in primary activities make inflation targeting unsuitable for India.

  5. You may also want to look at "Inflation Targeting in India: Issues and Prospects" by R. Jha


    "How Applicable is the Inflation Targeting Framework for India" by S. Chand and K. Singh

  6. Wasn't the Bretton Woods System of the 50s and 60s essentially an example of a global currency regime? Is a return to the pre 70s regime feasible in the present context of free capital and current accounts?

    Plese shed light on this.

  7. to shrikanth,

    A return to the Bretton Woods system is not possible as long as we have fiat money. And if, with volatile capital flows and countries with huge current account surpluses and deficits, we implement a pegged currency regime, it will be deflationary in some countries and inflationary in others.

    I am not sure we have enough gold reserves to support the kind of capital flows we have currently.

    In my opinion, it will be better for countries in the optimal currency areas to have a common currency. This will align business cycles and curtail fiscal profilgacy and the tendency of the Fed and BoJ to print money.

  8. yeah foreign banks are biased. They want RBi to intervene ? strange. All their reports from March april from their reseach desk paints pictures of huge RBI intervention. May be they want more of forex reserves to manage from their NY offices.

  9. Dollarize? I dare say your friends who make up the "financial interest" in Bombay might have something to say about that. Surely hoping for the steady penetration of Government institutions by this interest, leading to gradual market development, is better than annihilating it and forgoing politically-critical monetary sovereignty altogether?

    I realize you're being slightly facetious in this suggestion, but once more you betray that neoliberal tendency for utopian, quick-fix solutions by doing so. When will you lot realize that people will not play musical chairs with their lives with global finance calling the tune? In the immortal words of Princess Leia, "The more you tighten your grip, the more [human] systems will slip through your fingers."

  10. I am crystal clear that in a first best world, India has monetary policy autonomy plus an open capital account plus a floating rate. But this subtle institutional dance, that is required to master fiat money, is not easy. It requires a sophisticated institutional capacity and fair knowledge of economics.

    We are now in the worst of all worlds. We have the inefficiencies and rent seeking of capital controls + lack of stable interest rates + lack of stable currency + lack of stable and predictable inflation + complete confusion in the minds of the market about what is going on.

    Dollarisation is not the best, but it's better than this. If we can't make it to first best, we should seriously consider it. Think about it: You'd have all of (a) an open capital account (b) stable currency (c) a well known and understood monetary policy regime. The only thing it lacks when compared with inflation targeting is: an autonomous monetary policy. But it'd be better than where we are.

  11. Dollarization would forcibly align India's business cycle with the US. Just take a look at the Irish property bubble to see why this is neither benefitial nor desirable.

    In the unlikely event that India dolarizes, The Feds monetary policy would be too accomodative for India, adding fuel to the inflationary fire.

    As it is we have asset price bubbles. Dolarization would only fuel those bubbles. And when the bubble bursts, neither of the three benefits you outline would be of any consequence.

  12. "The ideal thing is to have a consistent monetary policy regime. E.g. in the UK or the US, economic agents are not puzzled by the central bank; monetary policy decisions are not a source of risk."

    Surely you're joking?

    In one kind of view, it's the only source of not-already-priced-in risk...there's a reason why the Fed likes being gnomic, it's just that the RBI can't help but be that way.

    So, the real question is, as you surely know, what are the different kinds of risks available here? How do different interests within the RBI work themselves out?

    Or, are your neoliberal interests such that dollarization will do for any old entirely contrived reason?

  13. Fed is not the epitome of certainty you make it out to be. There is no consensus among "economic actors" about the course of monerary policy a few months down the line. Bear Stears projects federal funds rate to by 50 bps higher while Goldman and UBS project it be to 50 bps lower by the end of this year.

    A central bank can only be as certain as the data allows them to be.

    A bit of uncertainty may not be that bad afterall. Given the weak short term transmission mechanisms for monetary policy in India, the only way to RBI to have an impact is to pull things out of a hat.


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