Monetary policy challenges for RBI
The effectiveness of the transmission channels of monetary policy is not known in India
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Central bankers often defend what they are doing whereas the general public is not sure of what they are doing or how central bank actions will affect their well-being. Look at what has been happening in the US in recent weeks and months; many people, including economists, do not seem to believe what the Federal Reserve says or does. The Indian situation is different. Many Indian economic/business analysts hold a favourable view of the functioning of the Reserve Bank of India (RBI), right from the institution of the new policy framework and the formation of the monetary policy committee (MPC) to the use of regulatory reach to stabilize financial markets and commercial banks.
Is such optimism justifiable in the present uncertain economic and political situation? Let us raise a few analytical questions for introspection.
Firstly, how well do we know the effect of the official interest rate on consumption? The answer is, one suspects, not definitive since the effectiveness of the transmission channels of monetary policy is not known in India at this point in time. Not unsurprisingly, transmission mechanisms are found to be not effective even in most advanced economies (AEs).
Secondly, how well does the RBI know the process of formation of expectations?
Expectation surveys are often used, for example, in giving a forecast or a rough approximation to a forecast of inflation. But the stated expectations may not be the same as what might be called ‘functional’ expectations. In other words, the information given by the surveys may give an idea of what people believe in, but that does not mean that people will act on the basis of their beliefs in the real world. One must recognize that expectations based on information from surveys or any such means may not give good forecasts. The information obtained may contain noise or friction or may be plain sticky. Even updates of information may not give good forecasts. There is considerable evidence in the US that such updates have not reduced forecast errors because of the presence of stickiness or noise.
Many economists believe that without help from psychologists and sociologists it would not be possible to know how people form expectations. But as such help may not be forthcoming in the foreseeable future, one wonders how central banks can analyse micro-econometric evidence of the behaviour of different economic agents, an area that goes beyond looking at fan charts. Such an exercise is not easy and in any case has not been undertaken in the RBI or elsewhere in India or in other parts of the world.
Thirdly, the above situation raises a question about the use of official short-term interest rate as a policy tool even in a somewhat benign economic environment in India compared with the environment obtained in AEs. Liquidity management is not a policy tool: It is the ‘dharma’ of central banking.
Fourthly, how does the official interest rate affect the foreign sector and the asset markets? This question again has not been tested with empirical facts and with reference to the behaviour of agents to events, shocks or policy measures, both fiscal and monetary.
Finally, one could ask whether the central bank has any view of the macroprudential aspect of monetary policy. This is particularly critical now that it is well known that a number of commercial banks have high levels of stressed assets. As yet there is no definite path laid down to resolve the problem within the medium term. Till we have a seamless integration of macroprudential policy with monetary policy, we may have to be content with separate announcements of monetary policy measures and supervisory and regulatory measures almost at the same time.
It is heartening to learn that the MPC has met for two consecutive days and has helped the RBI provide a basis for the policy announcement. I have a few suggestions to offer based on my experience of working at an important African central bank that has had an MPC since 2010.
It would be best to promote credibility by ensuring that one or two external experts at least are present when the policy announcement is made by the governor along with the deputy governors and the executive director in charge of monetary policy. It would also be helpful if the process of decision making of the committee is given in the form of a paper for wider circulation.
The RBI is expected to publish the minutes of the MPC meeting on 18 October. This, however, would not be enough. It should also release the full text of each member’s intervention at the meetings in about four weeks from the date of the meeting. Such a statement would help market participants read the minds of each member of the committee and work out their own strategies to optimize their portfolios before the forthcoming meetings. Some idea may also be given as to whether the members of the committee are supported by some research facilities and assistance from the RBI prior to meetings. It would also be helpful to know if members are supported by assistants or advisers at the meetings or whether the meetings are held in camera.
One hopes the RBI would give serious thought to the concerns cited above and help improve the credibility that it has built over a long number of years.
A. Vasudevan is a former executive director, RBI, and former special adviser to the governor, Central Bank of Nigeria.
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