RBI governor on the art of monetary policy making

9 Sep 2023 , 07:54 AM

Obviously, you can argue on this subject endlessly, but that is not the point. The reason why this debate is gathering steam is that central banks globally find themselves facing up to a different type of macroeconomic scenario. Traditional assumptions of economics are being questioned. In the past, monetary policy was all about managing price stability and liquidity. It is still the same; just that the path has become a lot more complex and notoriously unpredictable. 

It is in this context that the recent speech made by the RBI governor, Shaktikanta Das, at the prestigious Delhi School of Economics (DSE) assumes significance. This is an institution that has produced some of the best minds in Indian economics and policy making. This time, the topic of the governor ‘s speech was slightly off the regular route. It was about the art of monetary policy making. One would be inclined to wonder; where is the art in something as dry and prosaic as monetary policy. However, the RBI governor would like you think otherwise. 

Art of monetary policy in flexible inflation targeting

Central banks globally have been known for their obsession with price stability. Be it the erstwhile Deutsche Bundesbank or the ubiquitous Federal Reserve; the focus has largely been on price stability or inflation control. That would still be a very hard monetary measure. The art in monetary policy making comes in where there is more of discretion to be used. India adopted the Flexible Inflation Targeting (FIT) in 2016, where the inflation is targeted in a range around the median target inflation. Broadly, inflation is acceptable if it kept in this range and this range itself keeps shifting with the changing contours of the Indian economy. But why this obsession with inflation control and price stability.

Central banks globally, and India is no exception prefer low and stable inflation. The reasons are not far to seek. For households, inflation is the thief of value. So, lower the inflation, lower the time value loss, and hence lower the interest rates. That means, individuals and businesses can borrow at a reasonable cost and that makes their budgets more palatable. Also, low inflation encourages households and businesses to plan for long-term savings and investments rather than being obsessed with spending. This leads to higher savings, higher investments, and higher productivity. On the other hand, high inflation forces people to spend more today since they are worried about the value of their savings eroding rapidly in a rising interest rate scenario. 

There is also an inflation expectations angle to this art of inflation targeting. A lot of how inflation moves is determined by the expectations of people on the inflation front. For example, when the people are convinced that the RBI will intervene to raise interest rates and control inflation, the expectations are automatically capped. Hence, the RBI not only has to manage the actual inflation but also the expectations of inflation, which is what makes monetary policy an art.

Art of monetary policy takes off after Global Financial Crisis

In a sense the global financial crisis (GFC) of 2008, which was triggered by the collapse of Bear Sterns and Lehman Brothers almost brought the world financial markets to the brink For India, it also marked the culmination of years of high growth and relentless stock market rally. At that point, India had to contend with stubbornly high inflation with retail inflation in double digits. At the same time, growth was losing momentum, raising concerns of stagflation in India. India was already classified among the “Fragile Five” economies due to its overt dependence on global oil imports and the surge in oil prices. Things worsened 5 years later in 2013 when the taper talks led to concerns that the withdrawal of liquidity by the US could expose the Indian economy to shocks. That is when monetary policy had to chip in to play its part. That was also when inflation targeting was first mooted.

It was in the aftermath of the 2013 taper crisis that an expert committee was formed to address the twin deficits of CAD and fiscal deficit. One obvious answer was for the RBI to move to Flexible Inflation Targeting (FIT), which was officially announced in 2016. At that point, the inflation target was set at 4% with a flexibility of 2% band either ways. That means, inflation could be a minimum of 2% and a maximum of 6%. The new thinking also saw the shift from a Governor-centric monetary policy to a committee driven monetary policy, which his how the Monetary Policy Committee (MPC) came to be constituted. There were no more absolute powers in the hands of the RBI governor. The RBI governor vote would come into play only if there was a deadlock in votes by the committee. Otherwise, the RBI governor would be required to play along like a democratic leader, trying to build the consensus, rather than dictating the direction of monetary policy. While it made the process transparent, it also made monetary policy a lot more of an art.

Shift to forward looking monetary policy

One of the big changes in the monetary policy philosophy was that, post 2016, it became more forwards looking. It also came under pressure that while it had the luxury of being data driven, it had to be proactive rather than reactive. Hence, inflation forecasting and growth forecasting assumed a lot more importance in the process. This again made monetary policy an art. It was not just about the hard numbers but also about how the numbers were interpreted and how the numbers were communicated. We will deal with the aspect of communication of policy in greater detail later.

Here is how the RBI actually goes about these forward looking forecasts. Broadly, the forecasting process has 3 components viz. nowcasting, short-term forecasting and medium-term forecasting. Here are the key data points that are considered.

• Nowcasting uses high-frequency indicators for the current month or quarter and these include data points like PMI manufacturing, PMI Services, Composite PMI, e-way bills data, GST collections, freight data, cement, and steel demand etc. 

   

• The second component of short-term forecasts is normally upto a period of one-year. These are largely time-series and econometric methods, using aggregate and disaggregated data gleaned from forward looking surveys and lead indicators.

   

• Finally ,the third component involves medium-term forecasts and alternate scenarios. Here, the best case and worst case scenarios are projects and the stress test under each scenario is done to see how the economy could react. This can be very useful in times of surge in food inflation or spike in global crude oil prices. 

How art came into play during the monetary tightening cycle

Since late 2021, there have been talks of inflation going out of control and the need for monetary policy to proactively tighten the markets by cutting liquidity and raising rates. However, that was a complex situation. It had to be done without impacting the engine of growth, especially in the light of the nascent recovery post the COVID pandemic. That is why the US Fed waited till March 2022 and the RBI till May 2022 to actually start tightening the monetary cycle, again a case of monetary policy art coming into play. However, the normal assumption of moderation of inflation did not happen as expected. That is because supply chains were still tight and that, combined with robust jobs data, kept prices higher for a longer period. 

The real challenge for monetary policy as an art arises when there are factors beyond the control of the managers of the Indian economy. For instance, overlapping shocks of the pandemic and the Russia-Ukraine war raised significant challenges for monetary policy. Firstly, not just the median target of 4%, but even the peak target of 6% was put to test. Secondly, India had another challenge. It did not have the exorbitant privilege of the dollar, so it had to ensure that GDP growth did not falter. Today, it is a combination of creative monetary thinking that despite 250 basis points of rate hike by the RBI, India continues to remain the fastest growing large economy in the world, for 2 years in succession.

Managing expectations through communications

Like the Fed, even the RBI under Shaktikanta Das, takes its communication very seriously. It is not just about a drab statement to the bankers. It is a communication to the public at large about liquidity, cost of funds, inflation, and growth. As the RBI governor has himself underlined, managing expectations through effective communication is a vital instrument in the monetary policy toolkit. At the height of the pandemic during 2020 and 2021, the MPC prioritised growth over inflation and even communicated it clearly to the markets, with the possible risks and repercussions. Communication also becomes important when the macros do not live up to the expectations of the RBI. In fact, that is when conviction combined with communication becomes critical for the RBI. It is this importance of communicating the gist of the monetary policy in the right perspective that makes modern monetary policy so much of an art.