Making monetary policy more effective

Financial Express, 25 April 2007

The credit policy announced by RBI Governor YV Reddy on Tuesday left interest rates unchanged. Some view this as an indication that inflation is under control, credit growth is slowing down and so the RBI may go slow on raising rates. Others are still nervous. Further hikes in interest rates cannot be ruled out.

First, the two announcements between the quarterly credit policy statements suggest that the RBI does not change interest rates only on the quarterly credit policy dates. In December and March the RBI announced hikes in rates and the cash reserve ratio. The use of the CRR was in itself a surprise. In contrast to good global central banking practice where interest rate changes are announced on pre-announced dates, in India the sword of Damocles hangs on our heads.

Second, foreign exchange intervention in February and March may not have been fully sterlised yet. Since a CRR hike was to kick in on April 28, many observers were expecting that another hike would not be announced on April 24. But this does not mean that a hike cannot be announced later. In February the RBI injected Rs 56,780 crore into the economy through forex purchases. In that month MSS pulled out merely Rs 3,432 crore, while higher reserve requirements pulled out another Rs 7,000 crore from the monetary base. March saw lower purchases of net forex assets at Rs 20,641 crore. This was sterlised by a major step up in MSS to Rs 20,167 crore and higher reserve requirements which absorbed another Rs 7,000 crore from the monetary base. Data for April is still to come. CRR hikes are set to withdraw some of the net liquidity injected in February and March.

Third, while inflation may have fallen, it is still above the RBI's desired rate of 5.5 percent. The net impact of monetary policy on inflation is through the real interest rate. This rate, as the RBI indicated in its pre-policy review, is below what it was a year ago and is below that in major emerging economies.

Fourth, hikes in CRR and interest rates are instruments to sterlise RBI's forex intervention. If the public had full information about intervention, it would have an indication of what to expect. Data about intervention is published in the RBI's monthly bulletin with a two month lag. Some analysts struggle to work backwards from the data on forex reserves that appears in the weekly bulletin. But lack of information about interest payments on reserves and the composition of reserves means that such an analysis is at best a good guess. The effect of not knowing what to expect from monetary policy is a nervousness in financial markets. In advanced economies monetary policy works by managing expectations of agents in financial markets. Therefore, the first step in making monetary policy an effective instrument is to manage expectations better.

What needs to be done?

First, better information. RBI's foreign exchange assets is as much RBI's monetary policy as are the CRR rate hikes. It injects liquidity into the system. There is no reason why one should be done with no information to the public. At the end of each day this information should be put up on RBI's website. In addition, the RBI should publish data on net purchase of dollars in the Weekly Statistical Supplement.

Second, monetary policy announcments need to be made on pre-announced dates as in the US or UK. This tells people when to expect the next change. In the meanwhile officials can give clear signals about what is to come. Monetary policy works as much through people's expectations as through actual rate hikes.

Third, the RBI should not use CRR as an instrument of sterilisation. Open market operations/MSS should be used instead. When the CRR is raised banks have to do one of the following three things. Go out and borrow more, usually in high cost deposits. Sell off any holdings of government bonds in excess of SLR. Or, call in loans. No one is expecting banks to call in loans. Efficient banks, unlike 'lazy banks', who are involved in the business of banking do not have surplus holdings of government bonds and are thus forced to raise high cost deposits. This has to be done whenever the Central Bank suddenly announces a CRR hike. In contrast, open market operations through the MSS can allow RBI to sterilise its intervention whenever it takes place. It is optional for banks to choose to buy government bonds. This also leads to a rise in interest rates as higher rates have to be offered to persuade banks to buy government bonds but the net effect is a far more efficient and smooth system.

Finally, the market needs to clearly know what are the RBI's objectives. In recent months since it has become clear that there is a conflict between the objective of managing the rupee and managing inflation, the confusion about which objective is being given priority means that the market does not know whether the next day would see a sharp movement of the rupee, or whether it would be a smooth rupee accompanied by attempts to minimise the liquidity impact of RBI intervention. If people do not understand what the RBI wants to do and how it is going to do it, monetary policy will remain ineffective.

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