Evolution of monetary policy in line with the changing character of the economy

Evolution of monetary policy in line with the changing character of the economy

1935 to 1949: Initial Phase

 It is interesting to note that the Reserve Bank came into being in the backdrop of the great depression facing the world economy. Given the unsettled international monetary systems, the Preamble to the RBI Act, 1934 provided the edifice for the evolution of monetary policy framework. Until independence, the focus was on maintaining the sterling parity by regulating liquidity through open market operations (OMOs), with additional monetary tools of bank rate and cash reserve ratio (CRR). In other words, exchange rate was the nominal anchor for monetary policy. In view of the agrarian nature of the economy, inflation often emerged as a concern due to frequent supply side shocks. While the price control measures and rationing of essential commodities was undertaken by the Government, the Reserve Bank also used selective credit control and moral suasion to restrain banks from extending credit for speculative purposes.

1949 to 1969: Monetary Policy in sync with the Five-Year Plans

. India’s independence in 1947 was a turning point in the economic history of the country. What followed was a policy of planned economic development. These two decades were characterised not only by a predominant role of the state but also by a marked shift in the conduct of monetary policy. The broad objective was to ensure a socialistic pattern of society through economic growth with a focus on self-reliance. This was intended to be achieved by building up of indigenous capacity, encouraging small as well as large-scale industries, reducing income inequalities, ensuring balanced regional development, and preventing concentration of economic power. Accordingly, the government also assumed entrepreneurial role to develop the industrial sector by establishing public sector undertakings.

. As planned expenditure was accorded pivotal role in the process of development, there was emphasis on credit allocation to productive sectors. The role of monetary policy, therefore, during this phase of planned economic development revolved around the requirements of five-year plans. Even if there was no formal framework, monetary policy was relied upon for administering the supply of and demand for credit in the economy. The policy instruments used in regulating the credit availability were bank rate, reserve requirements and open market operations (OMOs). With the enactment of the Banking Regulation Act in 1949, statutory liquidity ratio (SLR) requirement prescribed for banks emerged as a secured source for government borrowings and also served as an additional instrument of monetary and liquidity management. Inflation remained moderate in the post-independence period but emerged as a concern during 1964-68.

1969 to 1985: Credit Planning

 Nationalisation of major banks in 1969 marked another phase in the evolution of monetary policy. The main objective of nationalisation of banks was to ensure credit availability to a wider range of people and activities. As banks got power to expand credit, the Reserve Bank faced the challenge of maintaining a balance between financing economic growth and ensuring price stability in the wake of the sharp rise in money supply emanating from credit expansion. Besides, Indo-Pak war in 1971, drought in 1973, global oil price shocks in 1973 and 1979, and collapse of the Bretton-woods system in 1973 also had inflationary consequences. Therefore, concerns of high inflation caused by deficit financing during 1960s gathered momentum during the 1970s. Incidentally, the high inflation in the domestic economy coincided with stagflation – high inflation and slow growth – in advanced economies. In such a milieu, traditional monetary policy instruments, viz., the Bank Rate and OMOs were found inadequate to address the implications of money supply for price stability. As banks were flushed with deposits under the impact of deficit financing, they did not need to approach RBI for funds. This undermined the efficacy of Bank Rate as a monetary policy instrument. Similarly, due to underdeveloped government securities market, OMOs had limited scope to be used as monetary policy instrument. During this phase, the average growth rate hovered around 4.0 per cent, while wholesale price index (WPI) based inflation was around 8.8 per cent.

1985 to 1998: Monetary Targeting

 In the 1980s, fiscal dominance accentuated as reflected in automatic monetisation of budget deficit through ad hoc treasury bills and progressive increase in SLR by 1985. Concomitantly, inflationary impact of deficit financing warranted tightening of monetary policy – both the CRR and Bank Rate were raised significantly. The experience of monetary policy in dealing with the objectives of containing inflation and promoting growth eventually led to adoption of monetary targeting as a formal monetary policy framework in 1985 on the recommendations of the Chakravarty Committee. In this framework, with the objective of controlling inflation through limiting monetary expansion, reserve money was used as operating target and broad money as intermediate target. The targeted growth in money supply was based on expected real GDP growth and a tolerable level of inflation. This approach was flexible as it allowed for feedback effects. CRR was used as the primary instrument for monetary control. Nonetheless, due to continued fiscal dominance, both SLR and CRR reached their peak levels by 1990.

. The worsening of fiscal situation in late 1980s was manifested in deterioration of external balance position and collapse in domestic growth in 1991-92, in the backdrop of adverse global shocks – the gulf war and disintegration of the Soviet Union. The resultant balance of payments crisis triggered large scale structural reforms, financial sector liberalization and opening up of the economy to achieve sustainable growth with price stability. Concurrently, there was a shift from fixed exchange rate regime to a market determined exchange rate system in 1993. In the wake of trade and financial sector reforms and the consequent rise in foreign capital flows and financial innovations, the assumption of stability in money demand function as well as efficacy of broad money as intermediate target came under question. At the same time, there was a notable shift towards market-based financing for both the government and the private sector. In fact, automatic monetisation through ad hoc treasury bills was abolished in 1997 and replaced with a system of ways and means advances (WMAs). During this period, average domestic growth rate was 5.6 per cent and average WPI-based inflation was 8.1 per cent.

1998 to 2015: Multiple Indicators Approach

 As liberalisation of the economy since the early 1990s and financial innovations began to undermine the efficacy of the prevalent monetary targeting framework, a need was felt to review the monetary policy framework and recast its operating procedures. As a result, the Reserve Bank of India adopted multiple indicators approach in April 1998. Under this approach, besides monetary aggregates, a host of forward looking indicators such as credit, output, inflation, trade, capital flows, exchange rate, returns in different markets and fiscal performance constituted the basis of information set used for monetary policy formulation. The enactment of the Fiscal Responsibility and Budget Management (FRBM) Act in 2003, by introducing fiscal discipline, provided flexibility to monetary policy. Increased market orientation of the domestic economy and deregulation of interest rates introduced since the early 1990s also enabled a shift from direct to indirect instruments of monetary policy. There was, therefore, greater emphasis on rate channels relative to quantity instruments for monetary policy formulation. Accordingly, short-term interest rates became instruments to signal monetary policy stance of RBI.

 In order to stabilise short-term interest rates, the Reserve Bank placed greater emphasis on the integration of money market with other market segments. It modulated market liquidity to steer monetary conditions to the desired trajectory by using a mix of policy instruments. Some of these instruments including changes in reserve requirements, standing facilities and OMOs were meant to affect the quantum of marginal liquidity, while changes in policy rates, such as the Bank Rate and reverse repo/repo rates were the instruments for changing the price of liquidity.

 An assessment of macroeconomic outcomes suggests that the multiple indicator approach served fairly well from 1998-99 to 2008-09. During this period, average domestic growth rate improved to 6.4 per cent and WPI based inflation moderated to 5.4 per cent.

2013-2016: Preconditions Set for Inflation Targeting

16. In the post-global financial crisis period (i.e., post-2008), however, the credibility of this framework came into question as persistently high inflation and weakening growth began to co-exist. In the face of double-digit inflation of 2012-13, the US Fed’s taper talk in May/June 2013 posed significant challenges to domestic monetary policy for maintaining the delicate balance between sustaining growth, containing inflation and securing financial stability. The extant multiple indicators approach was criticised on the ground that a large set of indicators do not provide a clearly defined nominal anchor for monetary policy. An Expert Committee was set up by RBI to revise and strengthen the monetary policy framework and suggest ways to make it more transparent and predictable. In its Report of 2014, the Committee reviewed the multiple indicators approach and recommended that inflation should be the nominal anchor for the monetary policy framework in India. Against this backdrop, the Reserve Bank imposed on itself a glide path for bringing down inflation in a sequential manner – from its peak of 11.5 per cent in November 2013 to 8 per cent by January 2015; 6 per cent by January 2016 and 5 per cent by Q4 of 2016-17.

2016 onwards: Flexible Inflation Targeting

 Amid this, a Monetary Policy Framework Agreement (MPFA) was signed between the Government of India and the Reserve Bank on February 20, 2015. Subsequently, flexible inflation targeting (FIT) was formally adopted with the amendment of the RBI Act in May 2016. The role of the Reserve Bank in the area of monetary policy has been restated in the amended Act as follows:

“the primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth”.