Monetary Policies Rbi's Strategies

EXECUTIVE SUMMARY

RBI adjusted repo rates to tackle inflationary concerns driven by rising fuel prices and laid down a formal framework to guide monetary policy operations through two key components: a disinflationary policy for bringing down CPI inflation below set targets and introduction of “a revised liquidity management framework which aimed at aligning the weighted average call rate (WACR) close to repo rate and thus strengthening transmission in the money market.

The current account deficit was further widened by various other factors : slow global growth impacting Indian Exports, elevated global commodity prices supported probably by accommodative monetary policies of the advanced economies, abundant global liquidity, and near- zero interest rate, increase in the import of coal due to domestic supply and policy constraints and restrictions on iron ore mining activities. The Patel Committee recommendation that inflation should be the nominal anchor for the monetary policy framework led to the signing of the Monetary Policy Framework Agreement between RBI and the Government of India in February 2015.

There are a number of internal critiques on RBI’s strategy and implementation of IT- doubts about the accuracy of RBI’s inflation forecasts and expectations, allegations of RBI being less mindful of the growth and investments imperatives of a growing economy like India and issues with the transmission of monetary policy including concerns of the transmission being slow and incomplete, being significant on fresh loans, but muted for outstanding loans, being uneven across borrowing categories and being asymmetric over monetary policy cycles (higher during the tightening phase and lower during easing phase). For example, the US tries to maintain flexible exchange rates, open capital markets, and independent monetary policy, while countries belonging to Eurozone settle with the stable exchange rate, financial integration and zero monetary independence.

The fiscal problem could be compounded by the need to increase the interest paid on excess reserves, and vastly expand its reverse repo operations, in tandem with policy rate increases, to forestall large pools of liquidity destabilizing financial markets. Since using a single tool for achieving two separate objectives fall foul of the widely accepted Tinbergen Rule, this line of reasoning appears to strengthen the latter view that argues that inflation targeting has either failed or the link between inflation and employment/growth is no longer linear, and in any case consumer price inflation is no longer a serious concern in the way financial stability now is. First, there has been a realization that monetary policy should, therefore, return to its original mandate of financial stability as either an explicit additional target or abandon inflation targeting altogether as the target of monetary policy.

INTRODUCTION

Preamble to the RBI Act states “The primary role of the central bank, as the Act suggests, is monetary stability, that is, to sustain confidence in the value of the country’s money.... Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures”.

In this pursuit, the RBI is faced with the impossible trinity that has been a matter of concern for the emerging economies in particular. Countries across the world have faced, and bowed, to this impossible trinity. The first such incident included George Soros breaking the Bank of England in September 1992, a day still known as “Black Wednesday”. The Mexican peso crisis (1994–1995) where Mexico had to abandon its peg to the dollar after depleting its forex reserves to preserve the value of the currency, the 1997 Asian financial crisis (1997–1998) when Thailand, too, ran down its reserves before abandoning the dollar peg and the Argentinean financial collapse (2001–2002) are a few examples. As recent as in 2015, China bowed to this impossible trinity as well when it devalued the renminbi.

If we look at the countries of today, those like China who want to fix their currency and have an independent interest rate policy cannot allow free capital flow across its borders. However if we look at countries like Britain who have a fixed exchange rate and free and open cross border capital flows, having an independent monetary policy is an impossibility. Then there are a few countries who choose free capital mobility and monetary autonomy, it is their exchange rate which needs to be sacrificed.

We would in our report try to capture how the problem of impossible trinity has influenced Indian economy while studying and understanding how the monetary policy has evolved not only in India but in other countries as well. These analysis will ultimately lead us to make recommendations which we feel should guide our approach towards this impossible trinity in future.

The Impossible Trinity

The impossible trinity or Trilemma, which is a potent paradigm of open economy macroeconomics says that a country may not target the exchange rate, conduct an independent monetary policy and have full financial integration all at the same time. The Trilemma derives itself from the Mundell-Fleming framework. The challenge is very relevant in the Indian context in wake of its continual integration with the global markets in the last two decades.

Policy makers are forced to create a policy targeting a combination of two objectives as all three goals are not correlated with each other. This is evident looking at the current major economies. For example, the US tries to maintain flexible exchange rates, open capital markets, and independent monetary policy, while countries belonging to Eurozone settle with the stable exchange rate, financial integration and zero monetary independence. On the other hand China tries to maintain a stable exchange rate with an independent monetary policy, while controlling the capital market flows.

The problem of Trilemma is highly pertinent in India in lieu of its greater integration with the global markets, however, very few empirical studies have been performed to identify India’s monetary policy preferences (out of the three issues in the trilemma). This is mostly because for most of the last two decades India followed a pegged exchange rate and a relatively closed capital account which made it difficult to get the actual numbers. However, due to India’s movement away from the pegged