Monetary policy in changing environment

Any change, even a change for the better, is always accompanied by drawbacks, discontinuity, and perhaps discomforts. In the policy domain, change can mean a host of unintended consequences. Consider, for instance, monetary policy design, which includes working out the cost of money and the going exchange rate. A recent working paper poses the question: How should India adopt monetary policy in the light of changing economic circumstances?

The answers are the monetary framework would need to be evolved as India sustains the economic growth momentum and gets to be better integrated with the global financial system. The efforts to manage inflows have led to classic tensions in the policy process, with the so called impossible trinity exchange rate stability, domestic monetary independence and financial openness coming to the fore. What’s required is a fine balancing act so as to best adapt the policy regime to a changing environment.

Most financial global economies tend to experience more volatile capital flows, they do not necessarily experience more volatility in monetary conditions, monetary aggregates or exchange rates. The most global economies have indeed “adapted their policy regimes” to prevent capital flows from giving rise to volatility in monetary conditions. One specific policy stance, as capital account restrictions are liberalized, seems to be to shift to more flexible exchange rate regimes.

The research finds that financial globalization can positively affect monetary operations. For example, it can make central banks move away from direct quantitative interventions using, say, blunt policy instruments like the cash reserve ratio to more forward looking interest rate management that send clearer signals through the financial markets channel.

In any case, greater financial openness means a premium on active liquidity management by the monetary authority. However, shifting to an open market approach would necessitate the use of debt or deposit sterilization instruments by the central bank of a wide range of maturities, both short term and long term up to one year.

RBI (India’s central bank) already uses longer-term instruments termed Market Stabilization Bills and Bonds, in addition to the reserve requirements for banks, to sterilize the liquidity surplus. But so far RBI has depended more on its overnight operations via the Liquidity Adjustment Facility to curb short-term volatility in liquidity conditions.

The shift to a move open market approach on the part of RBI would involve the use of a full range of instruments. The idea ought to be to conduct fine-tuning operations along with more long term open-market central banking operations. It notes that financial openness requires that central banks ramp up their ability to forecast foreign exchange flows.

At a broader level, no clear-cut association between the policy regime adopted and the “degree of stability” in monetary conditions can be found.

The structural surplus of our banking system weakens the monetary transmission mechanism (MTM), read the transmission of policy rate changes of RBI to other market rates. Note that despite three consecutive 25 basis points hikes in the repo lending rate and four increases in the cash reserve ratio totaling 200 bps, yields on government securities have only gone up by about 30-40 bps over the past year. And given a weak MTM, inflation targeting seems some way away.

Since domestic asset prices are increasingly determined by global factors, monetary policymakers do need to pay greater attention to conditions abroad as well as those at home. The times are indeed changing.

The build-up of international reserves can have precautionary motives such as reduction of external vulnerability. However, a country can face a scenario when the cost of holding additional reserves may exceed the benefits. There may then be the need to adopt a policy to control reserve accumulation. Then, the authorities need not adopt a target, nor define an optimal level of forex reserves.

India’s low financial openness reflects in part of the restrictions in place on cross border capital transactions. In parallel, capital inflows are now close to 5% of GDP, well below the levels seen in the major financial centers, but high nevertheless. Meanwhile, capital outflows have averaged 0.4% of GDP since the beginning of the decade. Therefore there is the need to further liberalize the capital account, and opt for a more pro-active monetary regime.