Reforming the Monetary Policy

Monetary policy has become one of the most valuable tools for the administration and development of an economy. Its ability to control the money supply and influence interest rates has a far most influential reach than any other policy. One of the most significant reasons is that the time lag between implementation and result is the least among alternatives. Central bank policy reviews have become one of the most anticipated indicators, for both investors and general public alike.

The policy reviews provide and insight into the overall economic conditions and coming future central bank and government policy changes or tax alterations. The citizens eagerly wait for their newspapers to tell them if home loans are going to get cheaper, if the inflation is going to eat away their savings, is their neighbour going to buy a new car or a scooter, etc. On the other hand, businesses, foreign investors and economists get an analysis of the country’s current scenario and state of economy. Thus, that leads me to the point that how monetary policy has become a part of our daily affairs and that’s why it is so effectual.

However, with great power comes great responsibility. The central bank has to be more responsible about its  guiding principles. Thus, I feel the most significant facet of a central bank’s monetary policy is it’s objective. I say that because as we have seen in the past, different central banks set different objectives and so have varied approaches and of course giving diverse results. To keep it simple let me list down these broad objectives:

• Price stability or inflation targeting
• Economic growth and low unemployment

There has always existed a trade-off between these to policy objectives. Generally it is according to the history, social-political scenario or economic conditions of the country which configures the monetary policy planning.

The European Central Bank has its primary objective of monetary policy to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term. This conservative approach has been criticised by many to be neglecting growth and high unemployment. But, like I said there are social factors which influence as well. There are long memories of people in Europe specially Germany of hyperinflation. So they are sure to be conservative. On the other hand, USA’s fed follows a more aggressive policy of concentrating on economic growth. Although the fed has always claims to have been following a mixture of both.

What’s for the future?

This present crisis has exposed an unpalatable truth that the monetary policy has to be very dynamic and holistic in nature, in order to keep up with today’s ever-changing economic and international trade environment. A number of fresh approaches have come to light in the past one year.

One such is Macroprudential regulation. Financial stability was considered to be one of the ‘other’ objectives of the central bank. But, last year the banking crisis showed that we need better regulation of the system by the central bank which includes measuring cyclic macro prudential indicators and reviewing banks individually rather than setting just petty capital adequacy norms.

One of the other important roles of the central bank is the role of custodian of foreign exchange and maintaining reserves. This include policies targeting BOP surpluses and adjusting monetary policies keeping in mind the position of the current and capital account reserves. For some economies which have a fixed exchange rate system, this forex management forms a crux of the central bank policies. We could see central banks taking this up more seriously and making it one the core guiding principles, especially as globalisation has brought so many opportunities and equally challenging threats to domestic firms. Thus, it should get more attention then it presently gets.

Another interesting method is the multiple indicator approach with Reserve bank of India follows. It includes tracking a number of indicators on whose basis its monetary policy is drafted. I will discuss it at length in my next post.

As the world comes out of a difficult recession in many years, reform will not exclude the central banks as well. As an institution it has gained huge importance in our daily lives as well; and making it more robust, prudent and flexible should be the right way forward.

RBI policy review and my views

There is excess liquidity for sure both in the Indian and Global financial markets today. Thanks to the near zero interest rates in the developed world; it is felt that the developing world is sitting on asset pricing bubbles. So it is more interesting to notice how these bubbles can be spotted today. The 20% food price inflation is not just a problem in India, but the rest of the developing world as well. Also the stock market was defying all logic 3 months ago, but recent quarter results have quelled some fears of over valuations. Moreover even commodities including oil have staged an upward trend in prices, even though the developed world is still healing its wounds. Thus it is a very difficult situation for the RBI to be in today, especially to be overseeing the global economic rebalancing also taking place in Asia’s favour.

Governor Subbarao has dishonourably failed on his most important job of controlling inflation and maintaining the value of the note he himself signs. Such high inflation in a recovering economy can spell misfortune in subsequent cycles.

The inflation is putting increasing pressure on the economy and the common man, which is not a sign of healthy recovery. Also foreign flows of capital into India have been touching enormous amounts, and the weaker dollar is a nightmare for the exporters and RBI alike. But it was as expected that on Friday, 29^th January 2010 the RBI hiked its CRR by 75 basis points, as looks to mop up Rs. 36,000 crores of excess liquidity. RBI had indicated in its previous policy review in Oct 2009, of its intent to gradually withdraw monetary support, but had just increased the SLR back to 25%.

I was expecting 50- 100 basis point hike in CRR, and along with it increases in Repo rates as well. My analysis proved worthy on two grounds. First, the CRR rate would have been increased in a calibrated and gradual manner instead of giving sudden shocks to the financial systems. Second, the RBI would have succumbed to Manmohan Singh’s cabinet to control inflation.

However I do not expect a rise in bank rates and other rates too soon, because then the RBI leaves the door open to even more foreign capital inflows. This would nullify the desired outcome as more money would still be chasing the same amount of commodities. Also it will further cause the rupee to be more susceptible to the volatile dollar currency markets as the foreign investors would be looking to hedge their currency risks and attracting more speculative movements.

Could do better

Although we all feel that the RBI has done well enough to save the economy in the crisis and its previous prudent polices have indeed protected the banking system, but to me its recovery management has failed in many ways. Firstly, India witnessed a slowdown, not a recession, so the work was already half done. Secondly, the earlier populist fiscal policies of the government were more than a helping hand to its monetary policies. RBI’s ineffectiveness was visible initially (in last quarter of 2008) where banks refused to bring down their lending rates; especially at the time economy needed the most. Thirdly, its failure to control inflation is big embarrassment for the usually pompous banker. Governor Subbarao has dishonourably failed on his most important job of controlling inflation and maintaining the value of the note he himself signs. Such high inflation in a recovering economy can spell misfortune in subsequent cycles. What and how it unfolds precisely is difficult to predict just like today’s economic crisis.