Restructuring Monetary Policy

The policy measures announced by Reserve Bank of India (RBI) last Friday can forall practical purposes be dubbed a mini credit policy.

The Bank Rate was hiked by 200 basis points, the cash reserve ratio hiked by half a per cent, refinance limits were slashed, the import surcharge was hiked to 30 per cent and the stipulations regarding overnight positions were relaxed selectively.

The package was in contrast to the policies announced in October when Bank Rate was reduced by 100 basis points and a time frame for reduction in the CRR was announced. Interest rates were at a ten year low and the policy was geared towards creating an environment to facilitate further reduction.

 

While RBI is justified in fighting the depreciation of the Rupee by hiking interest rates, there is no denying the fact that the package goes contrary to what was announced in October.

Players in the debt market who had taken positions expecting interest rates to decline are crying foul while RBIs decision to hike the CRR and slash refinance limits effective overnight saw the treasury heads baying for the central banks blood.

Events over the last few months have created confusion in the market over the objectives of RBI, as recent policies are perceived to be inconsistent with Octobers policy.

Against the backdrop of what has occurred, this article flags a few issues relating to the formulation of monetary policy.

Given that RBI is going to have a market based policy response, is there a need for two credit policies during the course of the year? Would it be better if we had RBI outlining the objectives of monetary policy and the targets at the beginning of the year?

The underlying rationale of having two policies during the year on account of seasonality in the gross domestic product is not necessarily true. The system of bi-annual credit policies was a product of a scenario where India was heavily an agrarian economy and the need for credit was seasonal. Earlier, the credit was allocated according to the need of the different sectors of the economy and there was a busy season credit policy to take care of the food procurement needs around October.

Recent trends indicate that the share of the services sector in gross domestic product has increased while that of agriculture sector has declined (see graph). The share of the services sector is expected to go up and this would only reduce the sesonality further.

While the issue of collapsing two policies into one could prove to be contentious one, there are other less contentious issues which need to be addressed.

At the beginning of the financial year, RBI could possibly announce the stance of monetary policy. This brings on the question of the stance of monetary policy. What would be the objectives and who will define them? The instinctive response would be: let the government decide, for central bank's have always been integral part of the government's decision-making process.

Recent trends, however, show that central banks in many countries have been made independent of the government and given a charter of objectives by the legislature. The reason is that there are efficiency gains when there is clarity on the objectives of monetary policy. In most countries the primary objective assigned to central banking authorities has been inflation control, and not without reason.

Economists have also shown that the higher the mean rate of inflation, the lower the independence of its central bank. Secondly, the higher the variance of inflation, the lower is the independence of its central bank. Thirdly, the lower the degree of central bank independence, the higher is the public's speed of learning about changing objectives, the lower is average credibility, and the higher is the level of inflation uncertainty.

In New Zealand, for instance, the sole objective of Reserve Bank of New Zealand is to ensure price stability while the German Bundesbank has to ensure price stability with supporting the governments economic policy being the secondary objective. Interestingly, in New Zealand, the Governor is personally responsible for fulfilling the prescribed inflation target contracted with the government. If the target is not achieved, he is liable to be dismissed.

Among the countries that have recently had a relook at formulation of monetary policy is England, where in May 1997, the Labour government gave the Bank of England the task of delivering price stability while the other objective was to support the government's economic policy, including its objectives for growth and employment, without prejudice to the first objective.

The previous arrangements for monetary policy was described by the Labour government to be too short-termist, encouraging short but unsustainable booms and higher inflation, followed inevitably by recession. The Labour government wanted to make monetary policy more effective, open, accountable and free from short-term political manipulation.

The Bank of England (BoE) was given operational responsibility for setting interest rates and to ensure that there is no conflict of interest, it gave up is role as the government's agent for debt management.

Complete freedom in the formulation of monetary policy would require the government to stay away from issues related to exchange rate management. In England, for instance, the government retains the responsibility for determining the exchange rate regime. BoE, has been allowed to have its own separate pool of forex reserves to be used for purposes of intervention in support of its monetary policy objective. The government has also reserved the right to instruct the BoE to intervene in the foreign exchange markets by buying or selling the government's foreign exchange reserves. It is also mentioned that all such intervention will be automatically sterilised.

Decisions will be made by a new Monetary Policy Committee comprising the Governor, the Deputy Governors and six members and the minutes of the meeting and the record of any vote, will be released no later than six weeks after the meeting. The minutes of the meeting and the BoEs quarterly inflation report will help the general public form an opinion on its performance against the target it is set.

The Committee's performance will be reviewed and the BoE would have to report to the Treasury Select Committee and to the House and there will be a debate on the Bank's Annual Report in the House.

In the light of the international experience, the question of what should be the objective of monetary policy in India arises.

Ideally, the Indian Parliament should grant RBI autonomy to achieve a set of objectives. The government could retain the option of overriding the charter given to the bank subject to the legislatures approval. In India, there is a sufficient degree of internal cohesion despite political instability and the Indian parliament should be able to arrive at a consensus.

On its part RBI has expressed its views on more than one occasion. In its Annual Report for 1993-94, RBI had argued that for improving the effectiveness of monetary policy there must be a clear and unambiguous mandate for the central bank and the bank could be made accountable for its actions. The Annual Report of RBI for the year 1996-97 while calling for autonomy has called for clarity over the dominant objective of monetary policy. Autonomy has many dimensions, of which the most important relates to the conduct of monetary policy. History shows that successful monetary policy requires not only operational freedom for the central banks but also a clear enunciation of the dominant objective of policy. With the discontinuation of the automatic monetisation of the deficit, a major step towards functional autonomy has already been taken. However, there has to be a general consensus on the need to keep the inflation rate around a certain level, states the report.

A case can be made for giving RBI an inflation target to fulfill and there are empirical studies to show that inflation control is desirable. Studies conducted to ascertain the relationship between inflation, the household savings rate, public capital formation rate and the real output growth rate over the period

1951-96, have suggested that inflation has a negative impact on all three variables. The RBIs motive for following an anti-inflationary monetary policy has stemmed from evidence that there is a severe trade-off between growth and inflation in the Indian economy.

The Tarapore Committee had recommended that there should be an early empowering of RBI on the inflation mandate. The Committee has observed that such a mandate would necessarily need to provide for greater independence for the RBI which would enable vastly improved monetary management in the context of capital account convertibility.

Moreover, "there should be a medium term inflation mandate approved by Parliament and only Parliament should alter the mandate. Once the mandate is given, the RBI should be given freedom to use the instruments at its command to attain the medium-term inflation target," observes the report. The report also called for clear and transparent guidelines on the circumstances under which the mandate could be changed.

There is need for evolving a consensus on the targeted inflation rate. The Tarapore Committee recommended the mandated rate of inflation for the three-year period 1997-98 to 1999-2000 should be 3 - 5 per cent.

While countries with more independent central banks have had generally low rates of inflation, there are also examples of countries with independent central banks experiencing high rates of inflation. The reason these countries have experienced high rates of inflation is that low inflation rates cannot be achieved without fiscal discipline. Studies in the Indian context have confirmed that resorting to monetary financing set in motion a vicious circle of large deficit, higher monetary financing, more inflation leading again to a larger deficit and so on. Thus there is a need for a credible fiscal reform package.

As part of the second phase of financial sector reform the government should consider giving RBI operational freedom, in view of the possibility of capital account convertibility. If both the central government and RBI make a public commitment of inflation targeting, it will help in reducing the inflationary expectations of economic agents.