Monetary policy

Monetary policy is the process by which the monetary authority of a country controls the supply of [1] money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values. Indian Experience Consistent with the objectives and policy framework, the operating procedure of monetary policy in India has also witnessed significant changes. The choice of targets, instruments and operating procedure was circumscribed to a large extent by the nature of the financial markets and the institutional arrangements. During the monetary targeting period (1985-1998), while M3growth provided the nominal anchor, reserve money was used as the operating target and cash reserve ratio (CRR) was used as the principal operating instrument. Besides CRR, in the pre-reform period prior to 1991, given the command and control nature of the economy, the Reserve Bank had to resort to direct instruments like interest rate regulations and selective credit control. These instruments were used intermittently to neutralize the expansionary impact of large fiscal deficits which were partly monetised. The administered interest rate regime kept the yield rate of the government securities artificially low. The demand for them was created through periodic hikes in the Statutory Liquidity Ratio (SLR) for banks. The task before the Reserve Bank was, therefore, to develop the financial markets to prepare the ground for indirect operations. The year 1992-93 was a landmark in the sense that the market borrowing programme of the government was put through the auction process. This was buttressed by a phased deregulation of lending rates in the credit market. The Reserve Bank also brought down the SLR to its statutory minimum of 25 per cent by October 1997, while CRR was brought down from 15 per cent of net demand and time liabilities (NDTL) of banks to 9.5 per cent by November 1997. The automatic monetization of deficits was also phased out in April 1997. All these developments resulted in a decline in pre-emption of resources from the banking system from a peak of 63 per cent in 1992 to 35 per cent by 1997. The Narsimham Committee (1998), however, noted that the money market continued to remain lopsided, thin and volatile and the Reserve Bank also had no effective presence in the market. Therefore, it reiterated the need to transform the call money market into a pure inter-bank market and recommended the Reserve Banks operations to be market-based. Following these recommendations, the Reserve Bank introduced the liquidity adjustment facility (LAF) in June 2000 to manage market liquidity on a daily basis and also to transmit interest rate signals to the market. Under the LAF, the Reserve Banks policy reverse repo and repo rates set the corridor for overnight market interest rates. Thus, OMO including LAF emerged as the dominant instrument of monetary policy, though CRR continued to be used as an additional instrument of policy. The call money market was transformed into a pure inter-bank market by August 2005 in a phased manner. Concomitantly, to enable a smooth exit of non-banks, new instruments such as the collateralized borrowing and lending obligations (CBLO) were introduced in January 2003. With the introduction of prudential limits on borrowing and lending by banks in the call money market, the collateralized money market segments developed rapidly. Maturities of other money market instruments such as commercial papers (CPs) and certificates of deposit (CD) were gradually shortened to seven days in order to align the maturity structure.

Managing large and persistent capital inflows in excess of the absorptive capacity of the economy added another dimension to the liquidity management operations during the 2000s. Although, initially the liquidity impact of large capital inflows were sterilised through OMOs and LAF operations, given the finite stock of government securities in the Reserve Banks portfolio and the legal restrictions on issuance of its own paper, additional instruments were needed to contain liquidity of a more enduring nature. This led to the introduction of the market stabilisation scheme (MSS) in April 2004. Under this scheme, short-term government securities were issued but the amount remained impounded in the Reserve Banks balance sheet for sterilisation purposes. Interestingly, in the face of reversal of capital flows during the recent crisis, unwinding of such sterilised liquidity under the MSS helped to ease liquidity conditions. In response to the measures taken to develop the money market, over the years the turnover in various market segments increased significantly. All these reforms have also led to improvement in liquidity management operations by the Reserve Bank as evident from the stability in call money rates, which also helped improve integration of various money market segments and thereby effective transmission of policy signals (Charts 1). The rule-based fiscal policy pursued under the Fiscal Responsibility and Budget Management (FRBM) Act, by easing fiscal dominance, contributed to overall improvement in monetary management.

Notwithstanding such improvements at the short-end of the financial market spectrum, the transmission of the policy signals to banks lending rates has been rather slow given the rigidities in the system, particularly the preference for fixed interest rate on term deposits. Against the backdrop of ample liquidity in the system more recently, as banks have reduced their deposit rates, the effective lending rates would have shown further moderation (Chart 2).

Policy Formulation Processes The process of monetary policy in India had traditionally been largely internal with only the end product of actions being made public. The process has overtime become more consultative, participative and articulate with external orientation. The internal work processes have also been re-engineered to focus on technical analysis, coordination, horizontal management and more market orientation. The process leading to monetary policy actions entails a wide range of inputs involving the internal staff, market participants, academics, financial market experts and the Banks Board (Chart 3).

Several new institutional arrangements and work processes have been put in place to meet the needs of policy making in a complex and fast changing economic environment. At the apex of the policy process is the Governor, assisted closely by Deputy Governors and guided by deliberations of the Board of Directors. A Committee of the Board meets every week to review the monetary, economic and financial conditions and renders advice on policy. There are several other standing and ad hoccommittees or groups which play a critical role with regard to policy advice. An interdepartmental Financial Markets Committee focuses on day-to-day market operations and tactics while periodic monetary policy strategy meetings analyse strategies on an ongoing basis.