The working group on operating procedure of monetary policy – appointed by the Reserve Bank of India (RBI) – has done a timely and professional job in its report. Its findings are supported by empirical evidence and provide the rationale for recommendations it made in relation to the liquidity adjustment facility (LAF). However, a few caveats are in order.
First, the working group refers to the policy rates of different central banks. The proposal is that following them, India too should have a single policy rate and other official rates should be linked to it. The fact is that there is a hierarchy of policy or official rates. The cut-off or implicit yields in the auctions of treasury bills and dated securities are as much indicative of the policy stance of the central bank as the repo rate recommended by the working group. These rates cannot in any way be linked to the repo rate because they depend on the demand and supply factors in the market. As a governor of the Bank of England once said, the central bank is as much guided by the market in rate setting as it is the other way round.
The single policy rate obtains in the UK and Japan and it is the lending rate. The three key interest rates of European Central Bank (ECB) are: (1) the interest rate on the main refinancing operations (MROs), which normally provide the bulk of liquidity to the banking system. The Eurosystem may execute its tenders in the form of a fixed rate or variable rate tenders; (2) the rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem; and (3) the rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem.(See http://www.ecb.int/mopo/decisions/html/index.en.html). As far as the US Federal Reserve is concerned, its Discount Rate is as much a policy rate as the targeted Federal Funds Rate (FFR). In the normal course of things, purchases or sales of securities by the Federal Reserve, whether outright or temporary, are its principal tool for influencing the supply of balances at the Federal Reserve Banks and FFR. It is not clear whether the working group expects RBI to intervene in the market through open-market operations on a daily basis, as in the US, to influence the market rates.
The linking of a comfortable level of deficit or surplus as a proportion to the total Net Demand and Time Liabilities (NDTL) of banks, based on the results of the econometric exercises presented in Technical Appendix II, raises the question on its relevance to the estimated growth of the gross domestic product (GDP). Since the central bank has a multiple-indicator approach, it should take an overall view of conditions in the economy in relation to the expected GDP growth rate (nominal as well as real) and decide on the deficit or surplus that it can live with. A mechanical linking of the amount to NDTL can be misleading, especially when there are technical or autonomous factors, like currency in circulation and government balances with RBI that are beyond the central bank’s control. The reverse repo rate needs to be determined keeping in view, inter alia, the problem of carry trade and not the repo rate alone. The proper course is to intervene in the market to bring its rate within the desired corridor, irrespective of the size of the deficit or surplus.
The working group’s preference for the deficit mode in liquidity is influenced by its finding that monetary policy is more effective then than when the market is in surplus. Monetary policy is a means to an end. The objective is to promote growth with price stability. If the surplus mode does not pose a threat to price stability, then so be it. It keeps the rates lower than otherwise. One should normally expect a deficit situation in a growing country devoted to price stability unless there is money creation to finance fiscal deficits or there is a foreign inflow of funds that are not sterilised. The cash reserve ratio (CRR) is still very much in the armoury of many central banks, developed or developing. China has been using it to the hilt as RBI did in the past. Although I have argued elsewhere that it is not financial repression, as claimed by Western economists, the central bank may revisit the idea of paying interest on the reserves of commercial banks. In fact, both the Fed and European Central Bank pay interest not only on the required reserves but also on excess reserves — consider it yet another instrument for monetary policy! The cash reserve ratio should be the ultimate brahmastra for RBI to deal with liquidity problems, although in Hindu mythology it could be used only once.
The author is an economic consultant and was a former officer-in-charge in the department of economic analysis and policy at the Reserve Bank of India
