Modernising the monetary policy

Since monetary policy takes time to act on output and inflation, a forward-looking assessment is essential

The Finance Minister in his maiden Union Budget speech had observed that “it is also essential to have a modern monetary policy framework to meet the challenge of an increasingly complex economy. Government will, in close consultation with the RBI, put in place such a framework.” Indeed, the government, according to press reports, is working on modernising the monetary policy.

Varying objectives

The objective of monetary policy varies in different countries. In the U.K., the objective of monetary policy is to deliver price stability — implying low inflation — and, subject to that, to support the government’s economic objectives including those for growth and employment. Price stability in the U.K. is defined by the government’s inflation target of two per cent.

In the U.S., monetary policy has two basic goals: to promote maximum sustainable output and employment, and to promote stable prices.

In India, according to the Reserve Bank of India (RBI) Act, 1934, the objectives of the Reserve Bank are “...to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.” The formulation, framework and institutional architecture of monetary policy in India have evolved over time around these objectives — maintaining price stability; ensuring adequate flow of credit to sustain growth; and securing financial stability.

Modernising monetary policy framework should not be confused with another approach popularly called inflation targeting (IT) just because over the years, from 1990 to 2008, about two dozen countries adopted it, prominent amongst them being Australia, Canada, New Zealand, and U.K. IT assumes that price stability is explicitly the mandate and a quantitative target for inflation is publicly announced.

“Models which are used for forecasting inflation should be placed in public domain to establish credibility and inspire confidence”

Overall, monetary policy is based on a wide set of information that includes an inflation forecast; transparency in operations; and accountability mechanism. As can be easily noted, the IT approach mounts blinkers on the central bank and absolves it from other responsibilities: IT was in disrepute after the onset of the great recession in 2008. India resisted adopting IT all these years as it binds the central banker, and, after minting its own Multiple Indicator Approach in 1997, demonstrated its efficiency by following it meticulously to stave off the Southeast Asian Crisis as well as the great recession.

The monetary policy framework can be modernised by a number of initiatives which are successfully followed in other countries. In the U.K., every month, the Agent’s Summary compiled by the Bank of England’s (BoE’s) 12 agents, following discussions with 700 businesses, is published to assist the monetary policy makers in conjunction with intelligence from other sources. Similarly, in the U.S., the Beige Book, published eight times every year, is based on anecdotal information on current economic conditions collected by each of the Federal Reserve Banks in their respective districts through reports and interviews with key business contacts, economists, market experts, and other sources. The Beige Book is an important source of real time market intelligence for the Federal Open Market Committee (FOMC).

Another key component of modern monetary policy is Monetary Policy Committee (MPC) which consists of members from within the central bank and experts in the country. In the U.K., the external members of the MPC are appointed for three years by the Chancellor and such appointments of independent members are designed to ensure that the MPC benefits from expertise in the area of economics and monetary policy. Each member of the MPC has a vote to set interest rates and the MPC’s decision is not based on a consensus of opinion.

The standard practice in the advanced countries is to disseminate research and models that are being used for forecasting. Since monetary policy takes time to act on output and inflation, sometimes more than two years, a forward-looking assessment is essential. This forecast can be prepared with the help of large macro-econometric models. As the BoE has been actively engaged in IT, the modelling experience in the U.K. can serve as a good illustration.

The history of large macro-econometric models used in the BoE dates back to 1970s and though perfected over the years, the BoE still follows a multi-model approach to project inflation nine quarters in the future.

Initially, the BoE used to supply the projected path of inflation exclusively to the Treasury. Since adopting IT in October 1992, the BoE has been placing quarterly inflation report in the public detailing its assessment of inflation and growth along with methodology of computing fan charts, and assumptions and models used in forecasting. The inflation report helps the BoE share its thinking with the public, explaining the reasons for the decision.

Transparency, clear communication and forward guidance are other pillars of modern monetary policy framework. To enhance transparency in operations, the U.S. Federal Reserve Bank (FRB) prepares a quarterly report on balance sheet developments in addition to semi-annual reports to the Congress discussing the conduct of monetary policy and the future prospects along with a testimony from the Federal Reserve Board Chair. In the U.K., minutes of the MPC meetings, with the voting pattern are also released to public within a fortnight.

Forecasting inflation

To modernise the monetary policy in India, to begin with, regional report like the Beige Book can be initiated. As inflation impacts everyone in the country, appointments to the Monetary Policy Committee (MPC) should be made by the Government. As with Mission Mars, which took a year to complete, impact of changes in interest rates can be felt in an economy only a few months later. Hence, it would be useful to estimate the transmission mechanism and the time lag that a change in interest rate would take to impact inflation, investment and growth.

Therefore, models which are used for forecasting inflation should be placed in public domain to establish credibility and inspire confidence. In absence of such robust and trusted models, the markets would face uncertainty, misinterpret RBI’s initiatives and yield contrary results. Once these relationships are quantified, and after wider and informed public discussion, India can consider adopting Inflation Targeting to yield effective results.