Monetary policy remains an important economic policy tool in both developed and developing economies. As the institutional environment, both domestic and global, changes, so do the tasks of monetary policy. The monetary and financial system is much more complex today than in the past. Financial intermediation has reached a high level of sophistication, which itself has become a source of concern. The menu of financial products has expanded considerably.
The need for a central bank in India has long been debated. Finally, the Reserve Bank of India was established as the central monetary authority in 1935. Like all central banks in developing economies, the RBI played both a developmental and regulatory role. In its development role, RBI has focused on creating an appropriate financial infrastructure in the country.
India’s Monetary Policy Trends
The evolution of India’s monetary policy reflects the evolution of concerns over the past seven decades. During the first three decades after independence, the main concern of the government was to implement the plans. All policy instruments, including monetary policy, were geared towards this goal. The allocation of credit in line with plan priorities has become a major concern.
In terms of monetary policy, planners were talking about non-inflationary deficit financing. For example, the First Plan document said: “The judicious creation of credit, somewhat in anticipation of increased production and the availability of genuine savings, also has a part to play. Prime Minister Jawaharlal Nehru’s letter to RBI Governor Rama Rau, while accepting his resignation, was clear. It indicated that the government was the dominant partner and that the role of the Reserve Bank was to conform to broader government concerns. As long as inflation was subdued, this approach did not matter. During the 1950s, average annual wholesale price inflation was only 1.8%. In the 1960s, it was 6.2%. But in the 1970s, inflation reached unacceptable levels, jumping into double digits, and money supply growth had to be brought under control.
The 1980s saw a continuous exchange between the RBI and the Ministry of Finance on the control of inflation, and the need to contain the budget deficit and, more particularly, its monetization. Although this period recorded an average annual growth rate of just over 5%, the growth trajectory was uneven. The average inflation rate was close to 7%. The annual growth rate of M3 was 17 percent.
Dr Manmohan Singh, Governor, Meeting of Reserve Bank MG Ramachandran, Chief Minister of Tamil Nadu in 1983
The Chakravarty Committee, appointed to examine the functioning of the monetary system, submitted its report in 1985; he stressed the need for regulation of the money supply and wanted the growth of the money supply to be consistent with real growth and an acceptable level of inflation. He also stressed the need for close coordination between monetary policy and fiscal policy, as the growth of the money supply was driven by reserve currency and the most important factor determining the creation of reserve currency was credit. RBI to government. Even though the government accepted the recommendations in principle, the latter part of the 1980s still saw a higher budget deficit and higher money supply growth. All of this landed us in the crisis of 1991.
The early 1990s saw, as part of the liberalization program, profound changes in the functioning of the central bank. As ad hoc treasury bills are no longer issued, the automatic monetization of the budget deficit has come to an end. By moving to a market-determined interest rate, government securities became negotiable and enabled the emergence of open-market operations as an instrument of credit control. The dismantling of the administered structure of interest rates has helped the interest rate to emerge as a political tool.
Price stability and growth have always remained the major objectives of monetary policy. The uncertainty is about what takes precedence and under what circumstances. After 1997, RBI specifically talked about a multiple indicator approach. But the problems with multiple lenses remained the same.
Exchange rate management
After 1996, RBI had to face some new problems due to the change not only in the monetary policy environment but also in the exchange rate regime. In February 1993, India moved to a market-determined exchange rate regime, with the intervention of the RBI when needed. Between 1996 and today, India has faced at least three major disruptions in the global foreign exchange market. The first was the East Asian crisis, the second the global financial crisis of 2008-09 and subsequent tantrums in 2013, and finally the current situation.
RBI handled all these situations with commendable skill. But a big lesson is that it is no longer possible to deal with an external situation without acting on the internal market. Protecting the exchange value of the rupee also requires action in the domestic money market. Another lesson is that we cannot ignore what happens to the real effective exchange rate. Inflation differentials ultimately determine the exchange rate. Excessive capital inflows and outflows have a monetary impact, and ways to deal with these situations had caused disputes between the RBI and the government.
Financial stability had become an important objective of monetary policy. The RBI, in this regard, was to play a dual role – monetary policy authority; and regulator of banking and non-banking systems. While India escaped the impact of the 2008 global financial crisis due to long-standing restrictions on foreign investment by banks, the rise in non-performing assets (NPAs) in the banking system is become a concern since 2010.
In the evolution of monetary policy, a major change came in 2016 when the RBI Act was amended. The new monetary policy framework requires the RBI to hold consumer price inflation at 4% with a margin of plus or minus 2%. It is a kind of flexible inflation targeting, which corresponds well to the needs of our country. This is the right balance between the objectives of price stability and economic growth.
However, several aspects of the mandate remain unclear and may lend themselves to multiple interpretations. For example, how long can RBI stay beyond the comfort zone without undermining the spirit of the mandate? What importance should the RBI attach to the median value of 4%? Which is more relevant and central – 4% stability or being in the comfort zone? Interpretations may vary depending on the circumstances. But the spirit of the arrangement is that over a period of time the system should be close to 4%. We must recognize that 4% inflation itself is well above what developed economies deem appropriate. This has implications for the exchange rate.
As we move forward, RBI and government must recognize the important role everyone plays in governing the economy. It is in the interest of the government to cede certain areas to the central bank, allowing it to act according to its best judgment. We have to get out of a scenario of “fiscal dominance”.
August 14, 2022