Present scenario:

The banks met the requirement of SLR which has now come down from the high of 38.5 per cent to 25 per cent of net demand and time liability (NDTL). In addition, the banks were required to subscribe to the cash reserve ratio (CRR) which over the years has been reduced from 15 per cent to 10 per cent. After meeting the requirements of SLR and CRR, it is only a small proportion of the resources mobilised by banks through NDTL which were at the disposal of the banks for commercial lending. In this environment, the monetary authority targeted the growth rate of money supply (broad money defined by M3) in order to control price inflation. Thus, the targeting of money supply became an intermediate instrument at the hands of monetary authority for controlling inflation in the Indian situation.

While there were large year to year fluctuations in the rate of inflation, the money supply growth remained more or less in the range of 17 to 18 per cent per annum. In an environment of scarcity of goods, and companies' production being below the capacity in the goods sector, the targeting of money supply for controlling inflation succeeded very well in controlling inflation, and the year to year fluctuations in the price inflation reflected the seasonal factors in the availability of goods in the market. The view is now emerging that the monetary authority should move from targeting inflation or money supply to targeting interest rate.

Difficulties in change over:

The change over from inflation targeting through intermediate money supply growth to the interest rate targeting essentially implies no basic change in the principle because the money supply targeting represents a quantity, and the interest rate targeting represents the price of money; there is however, one difference in the sense that in the case of money supply targeting the practice so far has been to target M3 growth. But, when the interest rate targeting is made the guiding principle of monetary policy then one is looking for targeting the interest rate in the short-term money market which implies that the targeting of interest rate is on day-to-day basis; maybe, it could be 91-day T-bills, or 182-day T-bills or 365-day T-bills depending upon the judgment of the monetary authority. If this approach is adopted by the monetary authority, it would then be necessary to have the underlying consideration of money supply justified by the narrow money (M1) instead of M3 which has been used so far.

Secondly, if the short-term interest rate targeting is adopted as the guiding principle, then one assumes a proper integration of not only the banking system but the entire financial system because the interest rate determined have to be transmitted to the various financial institutions including banks so as to mobilise deposits. Thirdly, it may be recalled that in May 1985, the system of deregulating short-term interest rates was introduced by RBI and this led to the shifting of funds from one bank to another in order to earn high interest rates; this ultimately resulted in the convergence of the interest rate. In addition, it increased substantially the administrative cost for banks through the renewal of deposits. When these operational difficulties were brought to the notice of the monetary authority, the scheme was withdrawn. Now, in a highly computerised environment, the convergence in the interest rate could take place much faster and the banks will not be in an advantageous position to get benefit outof the deregulated interest rate. However, the monetary authority could form its own perception about the level of interest rate that is desirable both to control inflation and maintain stability of the exchange rate. It is on the basis of this, that the targeting of interest rate could become successful.

Economic policy-making: Targets and instruments:

The broad objective of the economic policy is to maximise collective welfare of the citizens. There are two policy routes, one is the route of fiscal policy the focus of which is on the rates of taxes, government expenditure both capital and revenue to impart growth impulses to the economy. The second is the stance of monetary policy which tries to control price inflation and the level of exchange rate. Symbolically, welfare contributed by the monetary policy can be written as:

W = H (^p, ^e)

Where ^p is the deviation from the targeted price level and ^e is the deviation from the targeted exchange rate. In general, the following sequences are involved in economic policy-making:

i. Defining the social welfare function, W,

ii. The quantification of the policy objectives or targets by monetary authority.

iii. Identification of the policy instruments and their assigning to the specified targets.

iv. Quantification or specification of the functional relationship between targets and instruments, and finally

v. Determination of the optimal policy.

Focussing on the monetary policy, the recent initiatives taken by RBI indicate that the monetary authority is interested in maintaining the price stability as also the level of exchange rate. However, the RBI is trying to change the paradigm from targeting of money supply growth (M3 or M1) to that of targeting the nominal rate of interest. Whether the RBI uses the intermediate instrument of money supply growth or short-term interest is a question best left to the judgment of the monetary authority but in order to achieve the targets of price stability (^p and exchange rate stability (^e) there is a need to maintain consistency between the targets and instruments employed.

Theory of economic policy making tells us that if the system is to work effectively, then it is necessary that;

i. The number of policy instruments should be at least as great as the number of targets,

ii. That all the policy instruments should be independent variables, and

iii. That the policy instruments should have a differential effect on the target variables (Jan Tinbergen: On the theory of economic policy, and Economic policy: Principle and design, 1952 ; and J Marcus Fleming: Targets and instruments, IMF Staff Papers, November, 1968).

In other words, if the central banking authority is trying to achieve the two targets of maintaining stability of price inflation and that of exchange rate, then it should institute two policy instruments which are independent of each other. For maintaining the price stability the money supply growth is one of the intermediate instruments.

Exchange rate

On a priority ground, the change over may appear exciting but before one switches over to targeting interest rate especially, the short-term, there is a need to have a proper view of the markets, not only the domestic markets but also the foreign exchange market because in the open system, the money could flow in and out of the economy which would have its impact both on the interest rate and the exchange rate. It would then mean that the monetary authority if they intend to control the rate of inflation as also the exchange rate, they must have a minimum of two intermediate instrument, the central banks should try to discover another instrument for targeting to achieve the twin objective of maintaining exchange rate stability and the price inflation.

To the extent exchange rate continues to remain stable, the authority may not feel the need to invoke another instrument and one could argue that continuing the interest rate as an intermediate target could well serve the purpose. But once there is an upheaval in the foreign exchange market induced internally or resulting from the external shocks, the need for another instrument would be felt to bring about stability in the exchange rate movements. If the exchange rate remains some what stable, the second instrument may not at all be necessary and the authority could go on pursuing targeting of interest rate. In the event of an upheaval taking place in the foreign exchange market from the external shocks, the monetary authority could be caught napping in devising at a short notice the second instrument. Whether this is conducive to the growth of the real sector or meeting the twin objectives of stability in price inflation and exchange rate is a question fraught with great uncertainties.

Conclusion:

Targeting interest rate, theoretically, assumes that all the domestic markets are well integrated in the sense that the short-term money market is well integrated with the long-term, credit and debt markets. It also assumes that whenever the interest rate rise in one market, the movement of funds from one market to other tends to equalise and generate an interest rate which is well aligned with the social rate of interest. Secondly, it assumes that short and long-term domestic markets are not only well-aligned among themselves but also well-integrated with the foreign exchange market where the interest rates thrown up by the movement of the funds from one market to other is equally consistent. With the exchange rate being determined in the foreign exchange market, to what extent the Indian short-term, debt and capital markets are well-integrated among themselves on one hand, and with the exchange rate markets on the other, requires to be empirically tested before the policy of targeting interest rate ispursued vigorously. Till such time, one need not abandon the use of money supply as an intermediate target to control price inflation.

The author is research director of Mega Ace Consultants Ltd