MONETARY POLICY

Mridul Saggar
(Professor of Practice, IIMK)

questions & correspondence: mksaggar@iimk.ac.in

May 6, 2023 EPGP Economic Environment Lecture-6: IIM, Kozhikode

 What will we cover in this lecture?..
2

▪ What is Monetary Policy?

▪ What are the objectives (goals) of Monetary Policy?
▪ What are the instruments of Monetary Policy?
▪ What are Unconventional Monetary Policies (UMPs)
▪ How does Monetary Policy actions transmit to its goals?
▪ What are Monetary Policy Frameworks (MPF)?
▪ What are Monetary Policy Operating Procedures (MPOP)?
▪ Inflation targeting and the current challenges in the conduct of Monetary Policy
▪ The importance of Central bank independence
▪ How has Monetary Policy Framework evolved in India?
▪ The current stance of Monetary Policy in India and the challenges it face
 What is Monetary Policy?
6

Negative Output Gap Peak

Boom
Actual GDP
Real GDP
Bust
Expansion Potential GDP
Peak Contractionary
Trough monetary policy

Positive Output Gap

Expansionary monetary and fiscal policies

Time
▪ MONETARY POLICY is application of MONETARY THEORY and APPLICATION of set of MONETARY INSTRUMENTS to achieve
MONETARY OBJECTIVES. Typically, but not always, the policy is operated by the monetary authority (central bank) through control of money
supply and short-term interest rates.
▪ Monetary Policy is important, because economies are subjected to endogenously propagated business cycles. It seeks to operate the economy close to
its potential output level by undertaking counter-cyclical stabilization and not allow it to wander much from there, else generate booms and busts
cycles that prove to be inflationary or deflationary entailing severe multi-year costs.
▪ Monetary policy seeks to predict business cycles with reasonable precision, consider lags in monetary policy transmission and keep output gaps small.
 Genesis of Monetary Policy
4

▪ The use of “fiat money” was first recorded in China around 1000AD
▪ first central bank (Sveriges Riskbank) was established only in 1866.
▪ The Great Depression of 1929-39 & the Great inflation of the 1970s
(breakdown of Phillips curve) – what went wrong?
▪ During 1978-80 annual CPI inflation in US surged from ~6% to ~
15%. Volcker raises the fed funds target from ~ 10% to ~ 20% in the
1980s.
▪ In 1989, RBNZ was given operational independence to achieve and
maintain price stability
▪ The global financial crisis of 2008, the world changed and so did the
monetary policy that resorted to unconventional tools
▪ We saw synchronous aggressive monetary tightening during 2021 &
2022, but global monetary policy is somewhat diverging now with
EME central banks having broadly completed tightening and AE
central banks need some more tightening to reach their terminal rates
in this cycle
 What is the Role (Objectives/ Goals) of Monetary Policy?
5

 Growth?  Financial Stability?

 Improving micro-economic  Low Inflation?
performance?  Price stability?
 Improving macroeconomic  Higher level of employment?
performance?
 Full employment?
 Long-run improvement in growth?
 NAIRU?
 Higher growth in short-run?
 maintaining natural rate of interest?
 Sustainable growth?
 Maintaining neutral rate of interest?
 Higher sustainable growth?
 Maximizing welfare of the
 Inclusive growth? population?
 Balanced growth across regions?  Some of the above?
 Potential level of output?  All of the above?
 More credit?
What are the instruments of monetary policy?
6

Outright Open
Market
Operations
Repos & (OMO)
Reserve
Reverse Repos/
Requirements/
Liquidity
Cash Reserve
Adjustment
Ratio(CRR)
facility (LAF)

Term Repos/
Long-Term Statutory
Repo Liquidity Ratio
Operations (SLR)
(LTROs)

Instruments

Sterilisation
bonds/ Market Refinance
Stabilisation Facilities
Scheme (MSS)

Standing
Marginal
Deposit Facility
Standing
(SDF)/ Reverse
Facility
repo rate Policy Repo
Rate
(overnight/7-
day/ 14-day)/
Bank rate
 Taxonomy of Direct vs Indirect Instruments of
Conventional Monetary Policy Tools
7

▪ Direct Instruments: they have one-to-one correspondence between

instruments and policy objectives and come from regulatory powers of the
central bank rather than market interactions
➢ Examples: directed credits, interest rate ceilings and floors, statutory
liquidity ratios, bank-by-bank rediscount quotas and reserve requirements
▪ Indirect instruments: they are market-based instruments generally aimed
to change the supply of bank reserves or central bank liquidity for non-
banks and have gained popularity over the last three decades replacing
central banks dependence on direct instruments that were conceived to be
market distorting. They involve lesser degree of regulation
➢ Examples: Open market operations – central bank repos/ reverse repos,
outright transactions in purchase and sale of securities, typically near zero
risk sovereign bonds; rediscount windows; primary market sales of central
bank paper; collateralised loans from central banks; credit auctions; FX
swaps
 What is this?
8
 Monetary Transmission: A Black Box that we can try to
peek into
9

This was Black Box. Black box is:

 A usually large, square room with black walls used as a space for theatrical
performances
 Something that is mysterious, especially as to function.

 A device or theoretical construct with known or specified performance

characteristics but unknown or unspecified constituents and means of operation.
 The Cockpit Voice Recorder + Flight Data Recorder

Bernanke, Ben S., and Mark Gertler. 1995. "Inside the Black Box: The Credit
Channel of Monetary Policy Transmission." Journal of Economic Perspectives, 9(4):
27-48.
 Monetary Transmission Mechanism..(1)
Interest Rate Channel
10

M↑→i↓→I↑→Y↑
where, M = monetary base (currency and bank reserves)
i = real interest rates
I = investment spending
Y = income (GDP) or output)

 Given that prices are sticky, real interest rates (i.e., inflation adjusted
nominal interest rates decline first in the short-run then in the long-run, in
line with the term structure)
 A decline in real interest rate lowers the opportunity cost in consumption
and investment causing private domestic demand to expand
 Monetary Transmission Mechanism..(2)
Exchange Rate Channel
11

M ↓ → i ↑ → S ↑ → NX ↓ → Y ↓
where, S = exchange rate (↑ is appreciation),
NX = net exports (exports – imports), Y=GDP

 Contractionary monetary policy raises interest rates and

appreciates domestic currency, which reduced net exports and
contracts aggregate demand
 Increased interest rate also brings in capital inflows that add to
appreciation pressures
 Monetary Transmission Mechanism..(3)
Asset Price Channel
12

Through Tobin q:
M ↓ → Ep ↓ → q ↓ → I ↓ → Y ↓
where, Ep = stock prices, q = the ratio of market value of the firm
to replacement cost of its assets
Through Wealth Effect on Consumption:
M ↓ → Ep↓ → W↓ → C↓ → Y ↓
where, W = net wealth; C= consumption

 Monetary policy also operates through the link between

money and stock or property prices.
Question to think: Does asset class matter for transmission?
(Liquid equities vs Illiquid houses and consumer durables).
 Monetary Transmission Mechanism..(4)
Balance Sheet Channel
13

M ↓ → i ↑ → EFP ↑ → net cash flow ↓ → adverse

selection ↑ & moral hazard ↑ → lending ↓ → I ↓
→Y↓
Where EFP = external finance premium

 EFP is the difference in cost between funds raised externally

(equity and debt) and internally (retained earnings)
 Monetary Transmission Mechanism..(5)
Bank Lending Channel
14

M ↓ → i ↑ → EFP ↑ → bank loans ↓ → I ↓ → Y ↓

 Effect is through demand and supply of bank loans as distinct

from balance sheet affects
 Keynesian Liquidity Trap
15

▪ A liquidity trap occurs when interest rates fall so low

(approaching ZLB) that everyone prefers to hold cash and not
bonds. They expect interest rates to follow one-way street,
rising at some point in future and not fall any more. Staring at
potential losses on bond holding they hold cash. So, if money
supply is increases (shift LM to the right), interest rates and
output level remains unchanged. Monetary policy cannot
stimulate spending by increasing monetary supply or cutting
interest rates any further. Only Fiscal expansion can aggregate
demand up (rightward shift of IS)

Liquidity
Trap
 Zero Lower Bound (ZLB) on Nominal Interest Rates
attenuates monetary policy efficacy
16

▪ when the short-term nominal interest rates fall to near zero, causing a
liquidity trap, conventional monetary policy is rendered ineffective.
▪ Negative nominal interest rates are ordinarily unlikely to be acceptable
to saver as he can rather hold cash.
▪ This problem was experienced by Japan in the 1990s
▪ ZLB was also in evidence after Fed lowered Fed funds rate to 0-0.25%,
but desisted from negative rates even though Taylor Rule suggested
target Fed funds rate at below 6%.
▪ Post-GFC, however, several European economies, including Sweden,
Denmark and euro area s started experimenting with negative interest
rates giving rise to UMPs
 What are Unconventional Monetary Policy Tools (UMPTs)?
17

▪ Negative Interest Rate Policies (NRIP): They were unconventional as they imply that the owner of excess reserves incurs a
cost for placing them with the central bank, thus defying conventional wisdom that ZLB is to be avoided for risk of falling
into liquidity trap. They influenced the formation of agents’ future rate expectations and opened up the possibility of ELB
below ZLB.
▪ Expanded central bank Lending Operation (LOs): In many jurisdictions, lending is an integral part of the central bank’s
toolkit, consisting of short-maturity operations designed to facilitate the implementation of interest-rate policies.
Unconventionally, starting GFC, central banks created new, large such facilities or extended ones to provide ample
liquidity to a wider array of financial institutions under considerably looser conditions allowing lower-quality collateral for
longer horizons and at a lower cost.
▪ Large Scale Asset Purchase Programs (LSAPs): central banks made large-scale purchases of assets going beyond short-term
treasury instruments, stretching OMOs unconventionally. The purchases included longer-term and private sector assets,
often not just for providing liquidity but in a bid to directly influence asset prices. These APPs in many cases represented a
form of credit allocation and fell outside the scope of conventional monetary policy. Purchases of government and private
sector debt reduced interest rates and associated risk premia, and thus helped improved monetary transmission in face of
breakdown of markets. This lowered borrowing costs and stimulated real economy.
▪ Forward Guidance (FG): FG as a UMPT signaled central bank’s willingness to pursue ultra-accommodative monetary
policies for an enduring period of fixed time (time-dependent) or till specified conditions prevail (state-dependent). This
helped shape private sector expectations and improved their risk appetite to spend or invest. But these commitments also
came in way of timely withdrawal of monetary accommodation.
 Why Depositors Accept Negative Interest Rates?
18

▪ “Conventional wisdom is that interest rates earned on investments

are never less than zero because investors could alternatively hold
currency. Yet currency is not costless to hold: It is subject to theft and
physical destruction, is expensive to safeguard in large amounts, is
difficult to use for large and remote transactions, and, in large
quantities, may be monitored by governments. ….in times of turmoil,
investors accept zero or negative nominal yields as a fee for safety” -
Richard G. Anderson & Yang Liu, Fed St. Louis (January 2013)

▪ “Thanks to debit cards, online payments and smart phone wallets,

physical cash has become relatively more burdensome and costly. An
ECB study found cash 11 times more costly as checks for handling
most transactions” – Out of Bounds, Greg, WSJ, March 4, 2015
Inflation surged due to recovery from the pandemic shock and disruption from the
Ukraine war but has started receding on improved supply-chains, monetary tightening
19

Headline Inflation in Advanced Economies (AEs) % Inflation in Emerging Market Economies (EMEs) %
12 20

10

15
8

6
10

2 5

Jul-22
May-20

Jul-20

Jul-21

Apr-22
Apr-20

Jun-20

Apr-21
May-21
Jun-21
Feb-20

Nov-20

Nov-21

May-22
Jun-22

Nov-22
Jan-20

Mar-20

Jan-21
Aug-20
Sep-20

Dec-20

Feb-21
Mar-21

Mar-22
Aug-21
Sep-21

Dec-21
Jan-22
Feb-22

Aug-22
Sep-22

Dec-22
Jan-23
Feb-23
Mar-23
Oct-20

Oct-21

Oct-22
-2
Jun-20
Jul-20

Jun-21
Jul-21

Jun-22
Jul-22
Apr-20
May-20

Apr-21
May-21

May-22

Apr-23
Aug-20

Nov-20

Jan-21
Dec-20

Aug-21

Nov-21

Apr-22

Aug-22

Nov-22
Jan-20

Mar-20

Mar-21
Feb-20

Sep-20

Feb-21

Sep-21

Dec-21
Jan-22

Mar-22
Feb-22

Sep-22

Dec-22
Jan-23

Mar-23
Feb-23
Oct-20

Oct-21

Oct-22

-5
Figures in bracket are available latest month's inflation rates Figures in bracket are available latest month's inflation rates
UK (10.1) Euro area (7.0) US (5.0) US (PCE) (4.2) Russia (11.0) Brazil (5.6) South Africa (7.0) India (6.4) China (1.0)
US (Core PCE) (4.6) Japan (3.2) Target (2.0)
After aggressive tightening, AE central banks near their terminal rates, EM
central banks done with their tightening cycles
20

Policy rate changes in Advanced Economies Policy rate changes in Emerging Market Economies

750
700 1750
650 1500
600 1250
550 1000
500
750
Basis points

450
500

Basis points
400
350 250
300 0
250 -250
200
-500
150
100 -750
50 -1000
0 -1250
Canada (425)
US (500)

UK (415)

Japan (0)
Iceland (675)
Czech Rep (675)

South Korea (300)

Norway (325)
New Zealand (500)

Euro area (375)

-1500

Indonesia (225)
Hungary (1240)

India (250)

China (-20)
Brazil (1175)

Mexico (700)
Peru (750)

Russia (1575; -1250)

Turkey (200; -1000)

S. Africa (425)
figures in brackets give basis point increase in policy rates in current tightening cycle so far
figures in brackets give basis point increase/decrease in policy rates in current tightening /
H1:2021 Q3:2021 Q4:2021 easing cycle so far
Q1:2022 Q2:2022 Q3:2022 H1:2021 Q3:2021 Q4:2021
Q4: 2022 Q1:2023 Q2:2023 (till 5th May) Q1:2022 Q2:2022 Q3:2022
Q4: 2022 Q1:2023 Q2:2023 (till 5th May)
Central banks undertaking slow-paced quantitative tightening (QT),
contracting balance sheets
21

45.4% of GDP
US$ 28.6 tn
 What is meant by Monetary Policy Framework (MPF)
22

▪ MPFs are the sum-total of the way the monetary policy is framed in an economy under the legal and
institutional arrangements for the same.
▪ It covers monetary policy objectives, intermediate and final targets, instruments to achieve the targets and
the objectives
▪ Operational framework is a part of MPF
▪ Independence and Accountability, Policy and Operational Strategy, and Communication (IAPOC) are three
important facets that determine the strength of MPF
 Types of MPFs: New Classification by David Cobham …(1)
23

full name acronym definition Loose monetary narrow stationary targets not well hit or
9 LMT
targeting wider targets attained
Multiple direct multiple exchange rates and/or controls on
1 MDC
Loose converging converging narrow targets not well hit
controls direct lending, interest rates, etc 10 LCMT
monetary targeting or wider targets attained
Pure exchange rate exchange rate fixed purely by intervention,
2 PERF
fix no monetary instruments in use
Loose inflation narrow stationary targets not well hit or
11 LIT
Augmented exchange rate fixed by intervention, some targeting wider targets attained
3 AERF
exchange rate fix basic monetary instruments in use
domestic currency 100% backed by foreign Loose converging converging narrow targets not well hit
4 Pure currency board PCB 12 LCIT
currency, no monetary instruments in use inflation targeting or wider targets attained

Augmented currency domestic currency 100% backed by foreign Monetary with

5 ACB monetary targets and exchange rate
board currency, basic monetary instruments in use 13 exchange rate MwERT
fixes or targets, monetary dominant
targeting
Unstructured ineffective set of instruments and incoherent
6 UD Exchange rate with monetary targets and exchange rate
discretion mix of objectives 14 ERwMT
monetary targeting fixes or targets, exchange rate dominant
Loose exchange rate narrow stationary targets not well hit or
7 LERT Monetary plus
targeting wider targets attained monetary targets and exchange rate
15 exchange rate M&ERT
Loose converging fixes or targets, primacy unclear
converging narrow targets not well hit or targeting
8 exchange rate LCERT
wider targets attained Monetary with monetary and inflation targets,
targeting 16 MwIT
inflation targeting monetary dominant
 Types of MPFs: New Classification by David Cobham…(2)

24

Inflation with monetary and inflation targets, inflation Currency union

17 IwMT 25 CU currency union
monetary targeting dominant membership
Monetary plus monetary and inflation targets, primacy Full exchange rate narrow announced stationary targets
18 M&IT 26 FERT
inflation targeting unclear targeting typically attained
Inflation with Full converging
inflation targets and exchange rate (fixes or) narrow announced converging targets
19 exchange rate IwERT 27 exchange rate FCERT
targets, inflation dominant typically attained
targeting targeting
Exchange rate with inflation targets and exchange rate (fixes or) Full monetary narrow announced stationary targets
20 ERwIT 28 FMT
inflation targeting targets, exchange rate dominant targeting typically attained
Inflation plus
inflation targets and exchange rate (fixes or) Full converging narrow announced converging targets
21 exchange rate I&ERT 29 FCMT
targets, primacy unclear monetary targeting typically attained
targeting
Exchange rate, Full inflation narrow announced stationary targets
ER&M three full targets (or fixes), whichever 30 FIT
22 monetary, inflation &IT targeting typically attained
dominant
targeting
Full converging narrow announced converging targets
31 FCIT
Loosely structured instruments not effective or objectives not inflation targeting typically attained
23 LSD
discretion coherent or both only partly so
full and effective set of monetary
Use of another Well structured
32 WSD instruments and coherent set of
24 sovereign’s UASC dollarisation or euroization discretion
objectives
currency
 MPF IAPOC Index shows central banks took rapid strides
during 2007-18 on improving MPFs
25

▪ Filiz, et al (2022) construct IAPOC Index for 50 AEs, EMs, and LIDCs for the period
2007 to 2018, using public information systematically collected from central banks’ laws
and websites.
▪ Overall, EMs and LIDCs on average lag behind AEs across various dimensions of MPFs
▪ However, the Index shows that MPFs are rapidly improving in LIDCs and continually
changing in EMs.
▪ Mapping policy objectives into the numerical targets remain a challenge. EMs and
LIDCs also stand to benefit from enhancing consistency between the tools used in
practice versus those declared ex-ante.
▪ All countries made forceful progress on communication across all its dimensions since
2007. LIDCs, in 2007, lacked communications such as policy announcements or a
monetary policy report (MPR). Now many LIDCs, apart from EMs, have these.
▪ However, de jure aspects of Independence and Accountability within the IAPOC index
have improved only slightly over time and across countries
 What are the monetary policy operating procedures
(MPOPs) that the central banks use
26

▪ The MPOPs are a set of procedures that help central bank maintain its operating target
▪ The operating target of monetary policy is an economic or financial variable, which the central bank wants
to control, and indeed can control, to a very large extent on a day-by-day basis through the use of its
monetary policy instruments.
▪ It is typically the variable the level of which the central bank decides, generally as a collegiate decision of a
monetary policy decision making committee like the Monetary Policy Committee (MPC).
▪ The operating target thus (i) gives guidance to the implementation officers in the central bank what really to
do on a day-by-day basis in the inter-meeting period, and (ii) serves to signal the stance of monetary policy
to the public.
▪ Typically, it is the short-term inter-bank interest rate that is used as an operating target – mostly overnight
uncollateralized, but also collateralized overnight or or the 7-day/14-day repo rates.
 Evolution of Monetary Policy Framework in India
27

▪ Credit budgeting till mid-1980s

▪ Monetary Targeting with feedback: 1985-1998

▪ Multiple Indicator Approach: 1998-2016; with interest rate as MPOP started since 2011

▪ Transition to Inflation Targeting started in 2014 and inflation targeting has been formally
adopted since 2016.

Bottom Line: No one size fits all; MPFs chosen must suit country-specific conditions.
However, with deepening of financial markets, interest rate operating target helps. credibility of
monetary policy is important
 Monetary Targeting was a distinct improvement from credit budgeting;
but with financial innovations money demand became instable
28

▪ Credit budgeting worked exclusively through direct

instruments of monetary control and repressed price signals in
the economy

▪ Monetary targeting worked well for sometime. Money demand

function was stable till early 1990s and enabled Reserve Bank
to relay on monetary aggregates

▪ However, with deregulation of interest rates, development on

active debt markets and financial innovations, money demand
function became instable
 Multiple Indicator Approach was a black box but worked well for long
supported by introduction of short-term intertest rate as operating target
29

▪ Quantity Variables
Reserve Money Interest rate Money, credit, fiscal deficit, rainfall, IIP,
as operating services sector activities, export-
operating import, BoP, capital flows etc.
target targeting
▪ Rate Variables
Money market rates, lending/deposit
rates, yield on G-sec, inflation rates,
asset prices, exchange rates etc.
▪ Interest rate operating targeting
Gradually the rate variables gained
prominence over quantity variables
▪ The two policy options:
Make an announced switch to interest
rate operating target or let there be
gradual shift?
An announced shift has an advantage
of better guidance to markets in a
transparent fashion that can prepare
markets well. The transition gets
better appreciated. It can be
accompanied by buy-ins from key
stakeholders.
 Augmenting Interest Rate operating procedures through with
forward-looking surveys: The RBI approach
30

Forward-looking Surveys
▪ Industrial Outlook Survey (IOS)
▪ Order Book, Inventories & Capacity Utilisation Survey (OBICUS)
▪ Services and Infrastructure Outlook (IOS)
▪ Professional Forecasters’ Survey (PFS)
▪ Credit Conditions/ Bank Lending Survey (BLS)
▪ Inflation Expectations Survey of the Households (IESH)
▪ Consumer Confidence Survey (CCS)
These surveys along with projections of growth and inflation are
continuing in the current Inflation targeting regime as major inputs
for MPC decisions
 Evolution of Monetary Policy Operating procedures in India
…monetary targeting phase
31

▪ During reserve money as operating target, it was important to 30 Reserve Money Adjusted Reserve Money

monitor the reserve money growth adjusted for reserve

Y-o-Y growth in per cent

25

requirement changes 20

▪ Formal research work in RBI in early 1990s suggested that 15

10
both narrow and broad money demand had become instable
5
with break points detected much earlier
0
▪ This prompted the shift to interest rate targeting

Dec-09
Sep-09
Jul-09

Jun-10

Jul-11
Apr-09

Aug-10

Feb-11

May-11

Oct-11

Jan-11
Mar-10

Nov-10
-5
 MPOP of RBI with interest rate as operational target
32

▪ Introduction of LAF in June

2000 was a game changer in
the Indian debt markets and
enabled the switch to interest
rate targeting down the line
▪ It enabled the interest rate
channel of monetary
transmission to become the
cornerstone of monetary
policy
▪ However, objectives and
instruments were blurred
during multiple indicator
approach
▪ Also, sudden surge in capital
flows posed liquidity
management problems
 Gains from shift to interest rate targeting through LAF
33

▪ It helped the transition from direct instruments of

monetary control to indirect and, in the process, certain
dead weight loss for the system was saved.
▪ It provided monetary authorities with greater flexibility
in determining both the quantum of adjustment as well as
the rates by responding to the needs of the system on a
daily basis.
▪ It enabled the Reserve Bank to modulate the supply of
funds on a daily basis to meet day-to-day liquidity
mismatches.
▪ It enabled the central bank to affect demand for funds
through policy rate changes.
▪ Most importantly, it helped stabilise short-term money
market rates. The call rate was largely maintained within
a corridor set by the repo and reverse repo rates
imparting stability to the financial markets in general
 Was LAF as it was started the best way to stabilize short-term
interest rates in an interest rate targeting regime?
34

▪ Two policy rates rater one confused markets

▪ Shifts from system liquidity surpluses to deficit or vice a
versa can cause fluctuations in interest rates that can be
wide and destabilizing. This is especially important for
EMEs where the width of the corridor are large, often of
100 bps or more.
▪ Fixing a policy rate in the middle of the interest rate
corridor have distinct advantages of (i) transparent and
clear communication to markets on stance and intended
rates, (ii) stabilizing the demand for bank reserves
around a very small range around the policy rate, (iii)
lesser interest rate volatility and (iv) improved monetary
transmission
▪ Symmetric corridors are in general better than
asymmetric corridors, though in some circumstances
asymmetric corridors can be used effectively for limited
periods
 Sterilisation through Market Stabilization Scheme (MSS) was an important
instrument for managing liquidity during interest rate targeting
35

▪ Faced with surges in capital flows, the need to intervene to prevent

large misaligned appreciation of the rupee, sterilization of liquidity
became an issue as RBI ran out of G-secs on its books
▪ On March 25, 2004, RBI signed an MoU with GOI to issue T-bills
and dated securities under Market Stabilisation Scheme (MSS) with
sequestering of the proceeds of MSS. These proceeds were held by
the GOI in a separate account with RBI.
▪ These sequestered amounts could be used only for the purpose of
redemption and / or buy back of the Treasury Bills and / or dated
securities issued under the MSS.
▪ India’s sterilization instrument was unusual. While countries like
Chile, China, Colombia, Indonesia, Korea, Malaysia, Peru,
Philippines, Russia, Sri Lanka, Taiwan and Thailand were issuing
central bank securities for sterilizing, Indian preferred to use G-secs
▪ Advantages: (i) markets remained unified and didn’t have to price
differently, (ii) central bank averted possible losses on its balance
sheet maintaining its high quality, (iii) sterilization was taken up in
a big way, (iv) instrument was also used to impart liquidity through
its unwinding when required.
 RBI’s current short-term interest rate corridor
36

Rate of
interest
MSF Rate
X+25 bps
(Ceiling)
Illustrative Call Money [6.75%]
Rate oscillations
X Policy Rate
(Repo Rate)
[6.5%]

X-25 bps Standing Deposit

Facility (Floor)
[6.25%]

Liquidity
Proposed Glide Path for Disinflation by Urjit Patel Committee

▪ The Committee to Revise and

Transition Path to IT Strengthen Monetary Policy
12 Framework (Chairman: Dr. Urjit
10.6 CPI-Combined (yoy)
10.0 Patel) submitted its report in 2014
10 9.2 9.5 9.5 9.5
advocating introduction of Inflation
8.0
8 Targeting Framework in India
▪ It suggested a glide path to 4% as
per cent

5.9 6.0 6.0 6.0 6.0 6.0

6 inflation target with an upper
4.0 4.0 4.0 4.0
tolerance band of 6% and lower
4 tolerance band of 2%
▪ After introduction of inflation targeting
2
2.0 2.0 2.0 2.0 this was successfully achieved
0 ▪ It also suggested headline inflation
measure as new CPI that was All-Indi
2007-08

2008-09

2009-10

2010-11

2011-12

2012-13

2013-14

2014-15

2015-16

2016-17

2017-18

2018-19

2019-20
monthly index in place of weekly WPI
inflation
 Tryst with Destiny: RBI and GOI achieved an institutionalised modern
monetary policy framework implemented since Oct 2016
38

▪ The Committee to Revise and Strengthen Monetary Policy Framework (Chairman: Dr. Urjit
Patel) had submitted its report in 2014 advocating introduction of Inflation Targeting
Framework in India
▪ A landmark ‘Agreement on Monetary Policy Framework’ was signed between President of
India acting through the MOF, GoI and the RBI on February 20, 2015.that formally paved the
way for inflation targeting
▪ RBI Act amended as part of the Finance Act, 2016 (Union budget 2016-17) that reset the
primary objective of the monetary policy explicitly to maintaining price stability, while keeping in
mind the objective of growth. It also provided RBI with legal mandate for inflation targeting
through decision-making by Monetary Policy Committee (MPC).
▪ The 6-member MPC was set up: Governor (Chairperson of the MPC with a casting vote in
case of a tie) and DG in-charge of monetary policy are ex-officio members; one more member
from RBI (appointed by the Central Board) and three external members (appointed by the
GOI) as experts in the field of economics or banking or finance or monetary policy. External
members appointed for a 4-years non-renewable term.
▪ Majority voting with each member having one vote. Governor cannot veto but has a casting
vote. The MPC will meet at least 4 times a year. It currently meets at least six times a year in a
bi-monthly cycle of scheduled meetings and at time have met additionally in off-cycle meeting
 What has been impeding monetary transmission in
India over the years?...(1)
39

Fiscal Dominance of Monetary Policy in India

▪ Automatic monetization of fiscal deficits till the early 1990s → Supplemental Accords in
the 1990s → FRBM Act in 2000s → Inflation Targeting MPA in 2010s: Fiscal dominance
has reduced considerably but not waned all together
▪ SLR remains a distortion, enabling financial repression by borrowing sometimes even at
negative real interest rates → Is being gradually reduced/replaced by LCR (currently SLR
at 18%)
▪ Small saving schemes weaken monetary transmission through infrequent resets and
substitution of bank deposits
▪ Interest rate subventions & loan waivers also attenuate monetary transmission
▪ On occasions tax distortions debilitates monetary policy
 What Impedes Monetary Transmission in India?...(2)
40

Presence of Large Informal Sector and non-institutional lending

▪ Informal sector as defined by ILO in 1972 covers tiny units, engaged in production, whose
activities are not recognized, recorded, protected or regulated by the public authorities.
ILO redefined it in 1993 as units engaged in production, primarily for generating
employment and incomes to the persons concerned either as own account enterprises or as
informal employers.
▪ Share of informal/ unorganized sector in India’s GVA is currently ~52%. Its share in
employment is around 86%
▪ While the share in GVA is fairly stable in recent years; its employment share had declined
from 93% in 2003-04 to 86.8% in 2017-18
▪ According to NSSO 77h Round (AIDIS), 2021, the share of non-institutional credit in
outstanding cash debt of rural households was 34% at end-June 2018 in 2013. Though this
weakens monetary transmission, its declining share from 93% in 1951 has helped in
improving the interest rate channel of monetary transmission
▪ Rate of interest charged by MFIs ranged between 18-36% before new MFI regulations
have somewhat lowered it; rural money lenders often charge more and indulge in usurious
practices that have little relationship with interest rates in institutional credit markets.
However, with increased reliance of MFIs for bank borrowings, the interest rate
transmission is improving.
 What Impedes Monetary Transmission in India?...(3)
41

Bank behavior amid Financial & Credit market frictions

▪ Banks costs of funds change slowly in response to a policy rate change, especially as term deposits
constitute 55% of total deposits (as of March 2022) and take time to be re-priced. But this share has
been declining over the years and was 64.5% in 2013, thus improving the transmission over the years.
▪ Banking sector is not sufficiently competitive with public sector banks accounting for ~60% of assets.
Banks are reluctant to pass on rate changes, especially in lowering lending rates as they tend to protect
their NIMs. However, the share of these state-owned banks was ~74% a decade ago and more
heterogenous banking sector on the back financial market development has improved competitiveness
and efficiency of the banking system.
▪ Corporate lending rates respond faster and such loans get re-priced, but deposit rates and household/
consumer loans do not get re-priced quickly as even floating rates have reset costs
▪ Even long-run pass-through of policy rate changes was found to be incomplete in earlier period of base
rate pricing of loans
▪ Transmission of policy rate changes to deposit and lending rates are conditioned by liquidity changes.
Transmission is stronger and faster in deficit liquidity conditions than surplus liquidity conditions.
▪ MCLR system introduced in April 2016 has helped improved monetary transmission considerably.
Under MCLR banks use one of the acceptable benchmark external to the bank, such as the RBI repo
rate, 91-day or 182-day T-bill yield, or any other benchmark market interest rate as developed by the
Financial Benchmarks India Pvt. Ltd (FIBIL). Transmission through these market rates is more potent
 What Impedes Monetary Transmission in India?...(4)
42

Some Other bottlenecks to Transmission

▪ High inflation debilitates monetary policy efficacy as with negative real returns
on deposits financial disintermediation occurs and gold & real estate become
preferred saving instruments. Such financial repression returned during the
pandemic period as immediate priority was to avert scarring and job losses in
the pandemic period, but policy rates now being raised ro make real rates
positive
▪ Increasing share of NBFIs weakens the monetary policy contractionary
impulses (via Gurley-Shaw hypothesis)
▪ Unlimited liquidity under LAF provided by RBI in the past had weakened
transmission and capping liquidity under LAF at fixed rates and developing
term repos at variable rates has helped improve transmission
 RBI holds policy rate; pauses in rate tightening cycle in its
April 2023 policy; but not pivots yet in stance
43

▪ MPC at its April 6, 2023 policy

unanimously decided to keep policy
repo rate unchanged at 6.5%
▪ It kept the stance of the monetary policy
unchanged: “The MPC also decided to
remain focused on withdrawal of
accommodation to ensure that inflation
progressively aligns with the target,
while supporting growth.”
▪ It increased its FY24 growth projection
marginally from 6.4% to 6.5%
▪ It decreased its average inflation
projection for FY24 from 5.3% to 5.2%
▪ RBI’s policy focus has shifted to
financial stability in wake of
uncertainty arising from banking crisis
in US & Europe and impending global
slowdown
 RBI continue to use policy interest rate (repo rate) to target inflation at
4±2% under a flexible inflation targeting (FIT) MPF
44

India gained from developing interest rate

operating target framework even under the
FIT regime that was introduced in 2016
▪ The transition to Inflation Targeting as MPF was
smooth as India was already communicating
monetary policy through short-term interest rate as
operating target
▪ FIT was introduced after large GFC stimuluses were
not winded back in time with recovery in real
activity leading to high inflation where various CPI
inflation measures showed that average inflation
was running at ~10% for six years. This loss of
nominal anchor prompted RBI to shift to IT
▪ IT clearly delivered disinflation gains as FIT period
delivered average inflation at 4% target without
much output sacrifice, It did not cause interest rates
to rise and other macro-parameters remained under
control
▪ Only during pandemic period has the inflation
breached inflation targets and this was conscious
decision to avert deep scarring and job losses during
the unprecedented COVID-19 shock
▪ RBI now has raised policy rates by 140 bps in the
current tightening cycle to fight inflation in
accordance with the inflation targeting framework