Monday, April 06, 2015

Making monetary policy more potent

Tamal Bandyopadhyay in Mint, and MC Govardhana Rangan in the Economic Times, worry about the lack of effectiveness of monetary policy.

RBI officials have hinted at taking `tough actions' if banks do not respond to changes in the policy rate by RBI. This seems to be a bit odd to me. In a well functioning economy, changes in the policy rate should propagate out through a market process and not central planning. If that market process is not working out okay, this calls for reforms of the underlying problems and not more central planning.

There are three components of the monetary policy transmission:

  1. The bond market: When the central bank changes the policy rate, the entire yield curve changes through yield curve arbitrage. This propagates all through the Bond-Currency-Derivatives Nexus. It impacts upon the exchange rate as currencies and bonds are tightly interlinked. It impacts upon the corporate bond market at all maturities as the corporate bond market is priced off the risk yield curve.
  2. The banking system: When the central bank changes the policy rate, competition between banks forces changes in lending and borrowing rates.
  3. The exchange rate: When the central bank changes the policy rate, this impacts upon capital flows and particularly debt flows. This changes the exchange rate. E.g. when we cut rates, less money comes in, which gives a rupee depreciation, which is expansionary.

These three channels rely on a sensible financial system. The first requires a bond market embedded in the Bond-Currency-Derivatives Nexus. The second requires a banking system. The third requires openness to debt flows and a flexible exchange rate. In India today, we have difficulties on all four counts:

  • RBI has failed on bond market development for 25 years. This has damaged the monetary policy transmission through the Bond-Currency-Derivatives Nexus.
  • RBI gives out two banking licenses every decade, and blocks foreign banks, so there is a lack of competition in banking. This has damaged the monetary policy transmission through the banking system: changes in the policy rate do not impact upon the rates at which banks borrow and  lend.
  • RBI has blocked debt capital flows. This has damaged the monetary policy transmission through the exchange rate.
  • RBI has emphasised exchange rate objectives. This has damaged the monetary policy transmission through the exchange rate. Things have become much worse on this count after 2013.

These four elements of RBI strategy have made RBI ineffective as a central bank. The journey to a strong and effective RBI lies in changing course on these four questions.

These four elements of RBI strategy are the barriers to make inflation targeting work. It is one thing to sign a Monetary Policy Framework Agreement, it is another to actually succeed in delivering the goods. Until the quality of economic thinking at RBI improves, we will ricochet from failure to failure.

It is important to see the triad of the recent reforms as tightly interconnected. Setting up the PDMA is important as it takes away a key conflict of interest, and leaves RBI free to focus on the inflation objective. Shifting bond market regulation to SEBI is important as it gives RBI the monetary policy transmission. These two moves are integral to inflation targeting. The people who argue against these reforms are those who are perpetuating a weak and ineffective RBI. The Ministry of Finance has been kind to RBI by doing three things, as opposed to only doing the Agreement.

The RBI is now 80 years old and faces existential questions. All these years, RBI staff could mumble some mumbo jumbo, and get away with it, as most people could not understand the mistakes in thinking. Now RBI is accountable for delivering on CPI inflation, where the target and the performance are three simple numbers. This is a whole new game. If financial sector reforms are now not undertaken, failure will be visible in public.


  1. When a smart (and supposedly educated) person like Rajan justifies insulating people from "undue" volatility in forex (where, undue is defined by his chicken guts) there isn't much hope for the country. Where are people like Arvind Panagriya when you need him to counter Rajan? Why do they go silent after joining government. Why don't we have aggressive to-and-fro public debate when someone like Rajan makes a trivially dubious statement? What is the point of NITI?

  2. Dear Ajay Sir,

    Can you please point out few resources/ readings to understand the Bond Market in India and the "Bond-Currency-Derivative Nexus" which you have talked about in this article.
    Also something related to Monetary policy transmission in India.

    Appreciate your kind help.

    Best Regards,



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