Making monetary policy more effective

The credit policy announced by RBI Governor YV Reddy on Tuesday left interest rates unchanged. Some view this as an indication that inflation is under control, credit growth is slowing down, and so the RBI may go slow on raising rates. Others are still nervous. Further hikes in interest rates cannot be ruled out.

First, the two announcements between the quarterly credit policy statements suggest that the RBI does not change interest rates only on the quarterly policy dates. In December and March, the RBI announced hikes in rates and cash reserve ratio (CRR). The use of the latter was a surprise in itself. In contrast to standard central banking practice worldwide, where interest rate changes are announced on preset dates, in India the sword of Damocles hangs over our heads.

Second, foreign exchange intervention in February and March may not have been fully sterilised yet. Since a CRR hike was to kick in on April 28 anyway, many observers were expecting that another hike would not be announced on April 24. But this does not mean that a hike cannot be announced later. In February, the RBI injected Rs 56,780 crore into the economy through forex purchases. In that month, the market stabilisation system (MSS) pulled out merely Rs 3,432 crore, while higher reserve requirements pulled out another Rs 7,000 crore from the monetary base. March saw lower purchases of net forex assets, at Rs 20,641crore. This was sterilised by a major step up in MSS, to Rs 20,167 crore, and higher reserve requirements which absorbed another Rs 7,000 crore from the monetary base. Data for April is still to come?CRR hikes are set to withdraw some of the net liquidity injected in February and March.

Third, while inflation may have fallen, it is still above the RBI?s upper limit of 5.5%. The net impact of monetary policy on inflation is through the real interest rate. This rate, as the RBI indicated in its pre-policy review, is below what it was a year ago, and is below that in major emerging economies.

Fourth, hikes in CRR and interest rates are instruments to sterilise the forex market intervention. If the public had full information on the extent of this activity, it would have an indication of what to expect. Data on dollar purchases are published in the RBI?s monthly bulletin with a two-month lag. Some analysts struggle to work backwards from the data on forex reserves that appears in the weekly bulletin. But lack of information on the composition of and interest payments on reserves means that such an analysis is guesswork, at best. The outcome of not knowing what to expect from monetary policy is nervousness in financial markets. In advanced economies, monetary policy works by managing the expectations of agents in financial markets. Thus, the first step in turning monetary policy more effective as an instrument is to manage expectations better.

What needs to be done? First, better information. The RBI?s foreign exchange assets are as much part of its monetary policy as the rate hikes. Dollar purchases inject liquidity into the system, and there is no reason to do this on the sly. At the end of each day, this information should be put up on the RBI website. In addition, it should publish data on net purchase of dollars in the Weekly Statistical Supplement.

Second, monetary policy announcments need to be made on preset dates, as in the US or UK. This tells people when to expect the next change. In the meanwhile, officials can give clear signals about what is to come. Monetary policy works as much through people?s expectations as through actual rate hikes.

Third, the RBI should not use CRR as an instrument of sterilisation. Open market operations/MSS should be used instead. When the CRR is raised, banks have to go out and borrow more, usually by way of high-cost deposits; or sell off any holdings of government bonds in excess of the statutory liquidity ratio (SLR) requirement; or, call in loans. No one expects banks to call in loans. Efficient banks, unlike ?lazy banks?, do not have surplus holdings of government bonds, and are thus forced to take high-cost deposits. This has to be done whenever the central bank hikes CRR. In contrast, open market operations through the MSS allow the RBI to sterilise its intervention as and when it occurs. Buying government bonds beyond the SLR limit is optional, and hence higher rates have to be offered to attract banks to buy them, which spells higher interest rates overall. The net effect, however, is a more efficient and smooth system.

Finally, the market needs to know the RBI?s objectives clearly. In recent months, since it has become clear that there is a conflict between the objective of managing the rupee and squashing inflation, the confusion about which objective is being given priority has meant that the market does not know whether the next day would see a sharp movement of the rupee, or whether it would be a smooth rupee accompanied by attempts to minimise the liquidity impact of RBI intervention. If people do not understand what the RBI wants to do, and how it is going about it, monetary policy will remain ineffective.

?Ila Patnaik is a senior fellow at the National Institute of Public Finance and Policy. These are her personal views