The past year has provided researchers, academics and practitioners of finance an extraordinary stage for expanding their understanding of changed dynamics of financial markets born of the emergence of a largely unregulated ?shadow? banking system (the SIVs, CDO-squareds, monolines and such other arcane jargon). Fascinating as the above subject is, the most debated issue has been the conduct of monetary policy, in particular the role of the Federal Reserve Board. The slew of responses that the Fed has ?innovated? have highlighted an important issue: the best means for a central bank to address multiple objectives during times of acute stress in financial markets. Forget about the received wisdom of moral hazard and market discipline. It is now clear that, in times of acute financial stress, central banks willy-nilly have to provide ?liquidity support? to their wards, given their systemic importance. This, however, interferes with management of systemic liquidity, which is crucial for maintaining the target policy rate, the basis of monetary policy. This is even more so than in normal times, when there are conflicts with other central bank objectives, one of which is facilitating payments. During the financial turmoil that began last year, for instance, the Federal Reserve could have eased the liquidity shortage by supplying the most liquid assets in the economy?bank reserves?but this would have driven market interest rates below the target rate and interfered with monetary policy objectives. The Fed had to develop new, indirect methods of supplying liquid assets such as the Term Securities Lending Facility, which swapped Treasury securities for less liquid collateral. To address this basic tension between money supply and monetary policy, an alternative approach to monetary policy implementation has attracted attention. In this context, a recent research paper from the Federal Reserve Board of New York (Keister, T., A. Martin and J. McAndrews, 2008, ?Divorcing money from monetary policy) has highlighted a method of conducting monetary policy more efficiently that will strike a chord in India. The basic insight of this approach is to remove the opportunity cost to commercial banks of holding reserve balances by paying interest on these balances at the prevailing target rate. My apologies, then, if the following looks a trifle technical; you will see that the basic insight is very simple.
Central banks operate in a way that creates a tight link between (reserve) money and monetary policy. Monetary policy is implemented through changing the supply of reserves in a way that money markets clear at the desired target rate. This is achieved either through requiring banks to hold a minimum account balance over a multi-day averaging period (as in the case of the Federal Reserve) or through symmetric channel systems (used by the European Central Bank and the central banks of England and Australia). Calibration of market rates to match the target rate is then achieved through open market operations. The RBI?s approach involves a combination, using the Cash Reserve Ratio (CRR) and the Liquidity Adjustment Facility (LAF) corridor.
The chart shows the basic mechanism. The floor system is a modified version of the channel system. The downward sloping curve represents demand for liquidity from banks. The deposit rate is set equal to the target rate, instead of below it. This is in contrast to the normal practice of setting the target rate at some point in the interior of the corridor. Then, the central bank chooses the level of liquidity it supplies in the market so that it intersects at some point of the flat part of the demand curve. As is obvious, there is then a range within which supply can adjust without changing the market interest rate away from the target. In contrast, under the current channel system, the target supply intersects the downward sloping part of the liquidity demand curve, as a result of which, moving the target supply left or right makes the market rate deviate from the target. Really, it?s as simple as that. The floor system also reduces another well-known distortion in paying reserve balances at below-market interest rates. This system is effectively a tax on holding these balances. This reserve tax raises banks? operating costs and creates a deadweight loss by driving a wedge between the price of banking services and the ?social cost of producing these services?. We recognise that the nuances of this approach are oriented towards developed money markets like the US, but the essence of the arguments remain unchanged in the Indian context. The current mix of monetary policy instruments is complex and the objectives can probably be achieved with a simpler and more calibrated system. As money markets in India become more liquid and transmission channels for monetary policy better defined, the need for adopting more efficient systems increases.
The author is vice-president, Business & Economic Research, Axis Bank. These are his personal views