MONETARY POLICY

Reflections on Analytical Issues in Monetary Policy

The Indian Economic Realities

A Vasudevan

T
Analytical issues have arisen in the conduct of flexible his paper attempts to point out some of the analytical
inflation targeting as the framework of monetary policy, issues that arise in the conduct of monetary policy in
the context of the adoption of inflation targeting as the
adopted formally by India in 2016, despite the noticeable
framework of the policy. Our effort is essentially to inform
downward drift in the inflation rate and concerns of policy-thinkers that the analytical issues need to be tested
many economists about its relevance in the light of the empirically. Such investigations, it is hoped, would ultimately
global financial crisis. Issues such as the framework’s result in revising, or at least reorienting, the theoretical edifice
surrounding the framework of monetary policy.
rationale, the medium-term inflation target, the
First, in order to understand Indian economic realities, it is
meaning of real interest rate in the Indian context, the important to know the contextual backdrop to the theory and
realism in respect of inflation expectations and of the operation of monetary policy. Reserve Bank of India (RBI) as
inferred logic of the yield curve, and the implications for India’s central bank is essentially “a full service central bank,”
unlike central banks in advanced economies (AEs), as was elo-
economic inequalities have been pointed out.
quently argued by former Governor Duvvuri Subbarao in 2010
at an international conference. He clarified his remark by stat-
ing that RBI plays many roles: as the monetary authority, as a
regulator of the banking and non-banking systems as also of
many other segments of the financial markets, including the
payment and settlement systems. The RBI also acts as the debt
manager for the central and state governments.1 The RBI, thus,
has enormous presence in the public policy space and is, there-
fore, required to not only be transparent of its actions, but also
communicate the rationale of its policy measures in a credible
manner. This would imply that the RBI would have to be
committed to and accountable for its actions.
Against this background, one has to closely inquire about
the RBI’s recently adopted monetary policy framework. The
RBI has formally and legally adopted flexible inflation target-
ing (FIT) as its policy framework since early 2016, almost a
year after an overall agreement on the need to have FIT be-
tween the central government and the RBI. The development
of institutional infrastructure required to set in place inflation
targeting took considerable time, as is evident from the fact
that the establishment of the Monetary Policy Committee (MPC)
was announced only towards the end of September 2016.2
Inflation targeting is adopted as the monetary policy frame-
work in a number of countries since 1989. Over time, most of
the initial inflation targeters have moved away from the pure
form to the flexible form. A good many famous names in the
economics profession and international bodies such as the
International Monetary Fund (IMF) have extended strong sup-
port to it.3 Almost all AEs have adopted it. A few emerging and
A Vasudevan ([email protected]) was Executive Director of developing economies (EDEs) have also announced that their
Reserve Bank of India and Special Adviser to the Governor, Central monetary policy framework would follow the inflation target-
Bank of Nigeria.
ing approach. In India, inflation targeting as a monetary policy
Economic & Political Weekly EPW MARCH 25, 2017 vol liI no 12 45
MONETARY POLICY

framework was not discussed in official reports and peer- the international standards over time, after gaining some
reviewed journals till almost 2013. This indifference could experience with the adoption of FIT.
have been due to the general impression that there was no se- It was recognised that FIT would not guarantee financial sta-
rious shortcoming with its predecessor, an eclectic framework bility. In the Indian case, financial stability is sought to be se-
famously known as “multiple indicator approach” (MIA). cured by a number of institutions belonging to a number of seg-
The fact that the MIA lasted for a long time, from 1998 till ments of the overall financial system. Thus, one has a securities
the adoption of FIT, and was not experimented with by any regulator to look after securities transactions, an insurance
other country made it an interesting novelty. Under the MIA, regulator relating to all insurance taking and insurance pay-
the RBI took into account all the economic and financial indi- ments, and a pensions regulator with regard to pension pay-
cators that influence the major objectives as specified in the ments and arrangements.8 The RBI will regulate banking and
preamble of the RBI Act, 1934. The preamble stated: non-banking business of deposit-taking. Coordination of differ-
Whereas it is expedient to constitute a Reserve Bank of India to regu- ent financial regulators was entrusted to a committee that works
late the issue of Bank notes and the keeping of reserve with a view to under the central government and the RBI. However, it is the
securing monetary stability in India and generally to operate the cur- RBI that brings out financial stability reports and helps evolve
rency and credit system of the country to its advantage. macro and micro prudential policies with regard to the banking
Monetary stability may be interpreted as denoting price and sector. These reports are in the genre of similar reports brought
exchange rate stability. Operating the currency and credit sys- out by many other central banks, particularly those in AEs.
tem in an advantageous manner is to utilise credit and cur-
rency systems to promote economic growth. Besides, the issue Analytical Issues
of currency and the keeping of reserves may be seen as point- It is useful to begin the examination of analytical issues in the
ing to (i) creation of money supply that would not jeopardise architecture of monetary policymaking by knowing the rea-
price stability, and (ii) keeping foreign exchange at a level that sons for establishing central banks. It is not merely for issue of
would help ensure that India’s exchange rate would not exhibit currency that central banks are set up, at least since the 19th
gyrations and affect the country’s economic prospects. century. It is also for overseeing the financial institutions, par-
Prior to the MIA, India had “monetary targeting” (MT) with ticularly the deposit-taking ones, and for conducting credit
“feedback” loop, as former governor C Rangarajan remarked.4 policy for furthering economic activities. This is not the narra-
The replacement of MT was explained in terms of the weaken- tive that one would get at first glance while going through Vera
ing of and volatile streak in the demand for money.5 In other Smith’s well-known work, The Rationale of Central Banking
words, targeting money supply growth was given up in favour and the Free Banking Alternative, first published in 1936. She
of a discretionary MIA. wrote that the establishment of central banks in opposition to
The MIA’s replacement by FIT was not based on any authen- a free banking system, was based on “political motives” as
tic study of the irrelevance or uselessness of the MIA in the well as “historical accident,” rather than “any well-considered
evolving economic and financial situation of the country. All economic principle” (Smith 1990: 4–5). As one goes through
that is advanced as an argument against the MIA is that it pro- the book, one realises that she recounted an important bit of
vides too much discretion to the monetary authorities and may the evolution of central banking in England.
lead to situations where monetary policy–fiscal policy coordi- When the Bank of England (BOE) was set up in 1694, it was
nation would be under a cloud. Advocates and supporters of to exchange favours between a needy government and an ac-
FIT prefer rule-based policy, partly because it reduces the commodating corporation. The BOE’S capital was all lent to the
scope for administering policy shocks. government and in return it was authorised to issue notes
Like most other central banks, the RBI began to announce, equivalent of its loans to the government. This sudden surge in
under both the MIA and FIT regimes, the short-term rate of notes produced currency inflation. It was this episode that
interest as a possible way of ensuring that output growth goes seems to have given rise to a belief that central banks need to
along with price stability. The replacement of the MIA with be prudent in the issue of currency, lest there be a rise in com-
inflation targeting was conceived from within the RBI from modity prices. To revert to historical facts, the BOE was given
around the beginning of September 2013 under the leadership more privileges. It became a banker to the government. It was
of former Governor Raghuram Rajan.6 Rajan strongly suppor- entrusted with the job of managing national debt as well. It also
ted and justified it on the grounds that the target of inflation became the only bank to issue notes by the Act of 1844. Soon
should correspond with the threshold rate of inflation needed thereafter, it became the sole bank to maintain cash reserves of
to optimise growth.7 The threshold rate, however, was not a commercial banks. The maintenance of bank reserves was the
unique or single number: it was expressed in the form of a reason why Walter Bagehot (2006) argued forcefully for the
tolerance band. The band ranged from 2% to 6%, with a mid- BOE to be the lender of the last resort. He believed that the BOE,
point of 4% to be obtained by the end of the medium-term as the central bank of the country, was “bound” to keep a good
period of three years. The tolerance band of 2 percentage amount of reserves of commercial banks to take care of finan-
points is high by international standards, which generally cial panic. Bagehot stated that as trade in England was largely
favoured one percent point on either side of the mid-point. It carried on with borrowed money, the amount of reserves
is, however, possible that the band could be brought down to should be used freely and vigorously so that there would be no
46 MARCH 25, 2017 vol liI no 12 EPW Economic & Political Weekly
 MONETARY POLICY

bank failures. As he put it, “the end is to stay the panic.” The largely taken care of. Central banks cannot and should not
central bank could charge a high rate of interest on the sum lent take recourse to the argument that their communication about
against all good banking securities (Bagehot 2006). support to stressed commercial banks would amount to moral
The point made by Bagehot assumes significance if one were hazard.13 Such a posture could lead to considerable uncertain-
to look at the evolution of the Federal System in the United ties about the final outcomes with regard to the functioning of
States (US). The Federal Reserve System was created in the US the financial system, since there is no one way of knowing the
“as a direct response to a series of banking crises” in 1901, behaviour of economic participants to such a standpoint. In
1907, 1913 as well as in the 19th century, as pointed out by Ben- fact, such a posture could further encourage the opportunistic
jamin Friedman (2008). The crises led to the shutting down of behaviour of banks.
much of the US financial system and impairment of the real It would be particularly important that the institutions
economy. Friedman argued that the new central bank would under the supervisory and regulatory jurisdiction of central
be charged with the need to “provide an elastic currency.” banks are safeguarded along with efforts to actively help other
Central banks, thus, have to act to stem any financial crisis. regulators like insurance, securities, and pension funds super-
Financial stability has to be the main reason why central vise and regulate the institutions under their respective juris-
banks are created. This point was not fully appreciated once dictions. A cooperative and coordinated institutional mecha-
the AEs began to experience stable economic conditions along nism to do research studies and to bring about periodical
with growth. It was taken for granted that stable economic financial stability reports is widely recognised as helpful, but
conditions would be largely secured if central banks under- may not necessarily be sufficient to provide comfort in the
take policies to control inflation. Low or stable inflation was large, complex nature of relationships that get interwoven
understood to promote growth. Cycles in economic activity among the financial institutions operating under the universal
would be taken care of by policy interventions of central banks banking model.
and governments. If one were to stretch this logic, the Great It is now better appreciated that once the financial position
Depression of the sort that took place in 1929–30 would have of financial institutions is under stress for prolonged periods of
to be regarded as an exception. The global financial crisis that time, say for a medium-term period of three years, monetary
emerged in 2007–08 was not foreseen even a couple of years be- policy cannot be pursued effectively under any framework.
fore the recognition of the crisis,9 even though the Asian eco- Central banks cannot afford to consider financial stability as
nomic crisis happened towards the end of the 20th century. secondary to their objectives and have to recognise that it is
The global financial crisis has thrown up an important clue, critical for efficient functioning of macroeconomic policies.
that central banks would have to reorient their thinking about
monetary policy and allied operations in a manner that takes Tinbergen Rule
care of concerns that go beyond issues of currency and infla- Once it is agreed that financial stability has to be a part of the
tion control. Even if there is no legal obligation on banks to policy frame of central banks, how will it fit into FIT? The FIT,
hold cash reserves with the central banks, as is the case in it is said, could have two objectives, but with a specified or
some AEs, central banks will have to help banks in financial assumedly specified hierarchy between the objectives. The
stress that may have been caused by the banks’ own “adverse two objectives in question relate to inflation control and stabi-
selection.”10 This is necessary essentially to ensure that peo- lity, and output stability or employment stability. Central
ple’s confidence in banks is not eroded. If the said stressed banks seem to believe, in line with the Tinbergen rule, that if
bank is a large one or one that has large exposures to other there are n number of objectives, they should have n instru-
banks at home and abroad as well as other segments of the ments of policy so that there would be appropriate identifica-
financial system, the bank’s customers would rush to with- tion of the system (Tinbergen 1952). Inflation control is the
draw money from the stressed bank. This would force custom- prime objective and effectively the only one in almost all cases.
ers of other banks to closely observe the financial strength of This argument follows from the implicit assumption that out-
their own banks. They might also begin withdrawing money put stability and output growth would follow from it. In addi-
more frequently and in larger quantities than they would oth- tion, optimisation of growth would take place not at zero or
erwise have done, irrespective of the assurances about safety negative inflation rate, but at a rate that is empirically proved
of deposits by banks’ managements. to be an optimal one, and thus, the threshold rate. A number of
Erosion of confidence in the banking system cannot be easily studies showed that while the threshold rate had been at about
erased even if managements say that the bank suspected to be 2%–3%, it had been 6%–7% in the case of the EDEs.14 Studies
under financial stress is “too big to fail.”11 Commercial banks’ in India also seem to suggest that the threshold rate would be
own communications, however sophisticated and reasonable around 6% (Vasudevan et al 1999).15
they may appear, would not assure the people of the safety
of deposits. Deposit insurance too does not seem to be the This special issue has been put together by Saibal Ghosh and Partha
answer to people’s concerns about the safety of their money.12 Ray who formally served as Advisory Editors for the purpose
It is only when central banks provide assurance to people, that and oversaw the commissioning, refereeing and final selection.
they will take necessary steps to restore the financial health of EPW is grateful to them for their help. —Ed.
all the financially stressed banks, will the people’s concerns be
Economic & Political Weekly EPW MARCH 25, 2017 vol liI no 12 47
MONETARY POLICY

No economic policy planner in India, however, swore by the The Indian FIT felt that the inflation target could oscillate be-
applicability of the Tinbergen rule to Indian economic reali- tween 2% and 6% during a medium-term period of three
ties. Almost all policy planners and central bankers of India till years, and should be at the mid-point of 4% at the end of the
recently felt that while inflation should be under control, out- medium-term period.20 In other words, the tolerance band on
put growth as well as financial development and stability either side of the midpoint would be two percentage points in-
should also be regarded as equally important.16 In addition, stead of the one percentage point that most AEs and some EDEs
there is recognition that price stability does not need to be seem to favour.
viewed in terms of only overall consumer inflation: it could The evolution of the midpoint, and forecasting it as an
also be viewed as stability of food prices. Whatever objective is inflation target at the end of the medium-term period, raises
considered as a primary objective, given only one policy an interesting question. Should one treat 4% at the end of the
instrument, it becomes necessary to empirically show that the said period as the threshold rate of inflation where output
policy instrument would transmit its influence effectively on growth would be optimised? Or, should 4% be treated as the
the specified primary objective. “normal” desirable rate of inflation? Neither of these questions
In reality, however, policy goals, policy designs, and policy has received enough attention in the debate on inflation tar-
tools or instruments cannot be viewed as distinct. They are geting in India.21
often in the form of mixed compounds. They interact. Again,
there is a problem of assigning a target to any one institution Taylor Rule
or sector because the same policy target also appears in the Most central banks consider the short-term interest rate as a
matrix of policymaking processes of other sectors and govern- best operational target of monetary policy. The framework of
ments or institutions (del Rio and Howlet 2013). policy should permit the central bank to control the operational
If the above argument is true, how can the Tinbergen rule target. Inflation targeting is one such framework. Instruments
be regarded as relevant to our times? To be fair to Jan Tinber- of policy are used to achieve the operational target. In modern
gen, it must be pointed out that he did note that policy mixes in days, the tools that most central banks use are a variety of in-
terms of targets, designs, and instruments often exist and struments—standing facilities, open market operations (OMO),
interact with one another. He stated that there cannot, a priori, cash reserve ratio (CRR), and quantitative easing (QE). Central
be an n×n objectives–instruments compatibility always. He, in banks control the operational target, such as the short-term in-
fact, went to the extent of saying that “complicated systems of terest rate, through the use of monetary policy instruments.
economic policy … will almost invariably be a mixture of The MPC decides upon the official rate and thereby gives the
instruments” (Tinbergen 1952: 71). The Tinbergen rule should, stance of policy to the wider public. The official rate decided
therefore, be taken as a scholarly caution to policymakers that upon by the MPC signals to the policy implementation wing of
having too many objectives or goals would mean that there the central bank what it should do on a daily basis to ensure
should be a sufficient number of policy instruments to achieve that the actual market call money rate does not deviate from
them over a given time horizon. the official rate. The intermediate target nowadays is often the
long-term interest rate, which is theoretically speaking amena-
Rationale for FIT ble to influence via the use of the operational target. The final
Advocates of FIT place a number of arguments, implicitly or target is the economic variable that the central bank aims to
explicitly, against discretion in policy on the grounds that it is achieve within a medium-term period. It is often the price sta-
inefficient and would lead to dynamic inconsistency prob- bility under the inflation targeting framework.
lems.17 A rule-based approach is superior and can be successful How the level of the short-term interest rate as the opera-
with incentive-oriented contracts and with exercising of pow- tional target is set is provided by the Taylor rule, which was
ers to regulate banks.18 Lars Svensson justified FIT on the first formulated in 1993 (Taylor 1993). The rule in its original
grounds that because of time lags between monetary policy form was stated thus:
actions and their effects on prices and the real economy, FIT R=r* + p + a (y-y*)-1) + b (p-p*),
will work well if central banks forecast for both inflation and where R is the target nominal interest rate that is policy-centric,
real activity, thus making it “forecast targeting” (Svensson r* is the equilibrium real level of the policy interest rate, y is
2010). A yet more powerful argument in favour of inflation tar- output, y* is the potential output level, p is inflation and p* is
geting is that central banks as well as governments can deci- the target for inflation, and a and b are parameters that de-
pher and aim at the threshold rate of inflation where growth scribe the response of the policy rate to deviations of output and
can be optimised.19 inflation, respectively, from their potential level and target rate.
In the case of India, the threshold rate of inflation, accord- The Taylor rule has not been officially proclaimed as neces-
ing to some studies, was placed at about 6%–7%, a number sary for arriving at the official nominal interest rate by any
that is consistent with the studies by scholars for a panel of central bank. But central banks typically refer to it as useful
countries that represent the EDEs. For the panel of countries under certain circumstances. It would be invalid if the demand
that fall under the category of AEs, these studies show that the for money function is stable. Again, it would not work in coun-
threshold rate would be between 2% and 3%. It is no surprise, tries where exchange rate movements leave significant effects
therefore, that the AEs accepted the 2% threshold as normal. on the economy. It is also very narrow in its scope. It hardly
48 MARCH 25, 2017 vol liI no 12 EPW Economic & Political Weekly
 MONETARY POLICY

takes into account issues pertaining to financial stability and statisticians as to how to gauge it. It is here that inflation
employment–output linkages. It would not work if the trans- expectations play a role.
mission mechanism of monetary policy is weak and uncertain
(Vasudevan 2014). Besides, r*, as Woodford (2003) suggested, Real Interest Rate
has to be adjusted in response to fluctuations in the “natural” Questions are raised as to what real interest rate constitutes,
rate of interest in the Wicksellian sense. The natural rate would now that interest rates have remained so low as to be near zero
vary in response to real disturbances in the economy. or negative for a good many years since the outbreak of the
The RBI gives an indication, if not firm forecasts, of inflation global financial crisis. The definitional identity, that real inter-
and real economic growth, but these indications are not based est rate is equal to actual or expected nominal interest rate
on any full-fledged economic models. But, its indication of minus expected inflation, is hardly helpful in understanding
inflation is regarded as firmer and is considered the final tar- the impact that the real rate of interest is supposed to have on
get of policy. How the short-term interest rate is set is not offi- investment and on income. As Cameron K Murray (2016) has
cially given, but at least one top executive of the RBI, Deepak pointed out, the real interest rate, mysterious as it is, does not
Mohanty, ventured to discuss the Taylor rule in policymaking have a real life counterpart, posing a problem for economic
before the academics. In a speech at the Delhi School of Eco- theory. As he reasoned, changing the real interest rate through
nomics in 2013, he presented an analysis of how the Taylor rule central bank operations would not change the real return on
would apply to India without necessarily endorsing it as a capital and stimulate investment through that channel be-
means of arriving at the policy interest rate (Mohanty 2013). In cause the price of capital is determined by the money interest
his view, the Taylor-type rule would be useful as an “addition- rate. This is exactly how J M Keynes (1936) viewed the real
al tool” in understanding the interrelationship among growth, interest rate in his classic work, The General Theory of Employ-
inflation and policy interest rate, as the interest rate channel of ment, Interest and Money, especially the chapters on marginal
monetary transmission seems to indicate that it could over efficiency of capital and trade cycles.
time gain in relevance. He used the Hodrick–Prescott (HP) fil- This is very different from the concept of the real rate of in-
ter to estimate the potential output with an adjustment for the terest that was propounded by Irving Fisher in 1930. The
information then available on output at 7% per annum. The difference in the viewpoints of Keynes and Fisher is aptly
“desired” rate of inflation was placed at 5% per annum. In his captured by Eric Tymoigne (2006).22 The main thrust of
view, the neutral real policy rate was 1%. On this basis, the Tymoigne’s argument against Fisher’s thesis is simply this: the
neutral nominal policy rate was estimated by Mohanty at 6% idea that variations in the money rate of interest on monetary
per annum. This view has not been contested subsequently by assets are the result of expected inflation is not tenable since it
any other executive of the RBI, or pursued by any other Indian cannot be firmly established. It is mainly for this reason that
researcher. Keynes provided the liquidity preference and marginal effi-
The Taylor rule has been treated with polite indifference in ciency of capital (the money rate of return on non-monetary
the literature when the recessionary conditions began to dom- assets) as a credible alternate explanation.
inate since the outbreak of the global financial crisis. It has Yet, the current notion that the real interest rate is essential
been found to be not sufficient to believe that the Taylor rule for the inflation targeting framework has given rise to the idea
would work without incorporating an appropriate proxy to fin- that monetary policy should be concerned with managing in-
ancial stability in the formulation of the rule. In fact, Charles flation expectations in order to keep the real interest rate at a
Goodhart (2010: 9) has gone to the extent of suggesting that a stable level, consistent with the point of equilibrium that helps
liquidity managing central bank that considers financial sta- equate saving and investment.
bility as critical for efficient functioning of the central bank There are, in real life, serious problems in choosing the ap-
need not necessarily set an official interest rate. Central banks propriate nominal interest rate and the appropriate measure of
traditionally have been managing liquidity and setting official prospective inflation to derive the real interest rate that would
short-term interest rates. In addition, if they were to adopt a have a positive impact on both saving and investment. Surpris-
tested regulatory framework in pursuit of financial stability, ingly, the RBI does not provide any clear and definitive guid-
they would wield enormous power in the economic sphere. ance in the matter. Should one take the official money rate of
This would inevitably raise questions of propriety and ac- interest as the appropriate nominal rate of interest, or the call
countability of non-elected bodies, such as the central banks, money market rate of interest and the consumer price inflation
in the modern-day discourse on democracies. for derivation of the real interest rate? Or, should one substi-
On an analytical plane, one could question the validity of a tute the official rate with a one-year treasury bill rate or with
number of these benchmark concepts that are built into the an average of one-year deposit rates that major commercial
Taylor rule. Often, benchmark concepts are not directly ob- banks offer? Should one take only the consumer price index
served. The equilibrium real interest rate is one such bench- (CPI) as the representative for proper basis for measurement of
mark concept, ignoring the word “equilibrium” for the present. expected inflation, when it is well known that food prices have
Potential output is yet another concept on which the latest esti- a very dominant weight in the CPI? Does more than 50%
mate of Bhoi and Behera (2016) is 6%. “Target inflation rate” weight for food not make the CPI vulnerable to supply shocks?
throws up a severe challenge to the abilities of economists and Neither has productivity in agriculture gone up in any discernibly
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MONETARY POLICY

sharp manner, nor is the seasonality factor easily foreseen part- It is also taken for granted, at least in theories of yield curve,
ly owing to the climate change factor. Should one not consider that long-term interest rates would be higher than the short-
inflation in India as more structural in character? If inflation is term interest rates because they carry risks—uncertainty
structural in character, how does FIT work efficiently? Should we about inflation and future interest rates. In addition, it is un-
then wobble between two extremes of the midpoint of 4% every derstood that even though both the short-term and long-term
two or three years? What if the fuel prices, which are known to be rates of interest have shown volatilities, the yield curve would
volatile, add to the uncertainty that food prices present? These are generally be smooth and upward sloping. Many economists
formidable questions that have to be researched before one con- have concluded that upward-sloping yield curves represent
cludes with certainty that FIT based on the changes in the overall relatively high and stable economic activity levels.24
CPI is the right framework of monetary policy. None of these beliefs seem to have worked well after the
recent global financial crisis. There were a number of times
Inflation Expectations when the yield curve appeared inverted both in AEs and EDEs
There are also many doubts about the process by which expec- in the last eight years, thereby highlighting that the yield
tations are formed. Here, one must make a distinction between curve may not always be a good leading indicator of the level
what economic agents express as their expectation of inflation, of economic activity. The yield curve–economic activity corre-
and what economic agents expect to do based on their revealed lation is not established in the case of the AEs from the quar-
expected rate. The latter is the effective functional form of terly observations of data in the last 10 years. Insofar as emerg-
behaviour, which may not be harmonious at the macro level. ing economies are concerned, it is much more difficult to prove
Most surveys in India of expectations of inflation provide re- that yield curves and economic activity levels are positively
spondents’ responses based on past experience and on some correlated, especially since the number of long-term bonds
information on the current indications about the direction of would be relatively small and less frequently transacted in the
movements in major macro indicators as reported for a quarter financial markets of emerging economies.
ahead. Much of the current information, it must be recognised, Has FIT in the AEs also led to inequalities? In recent years,
is not based on a firm information base and could well have there has been enormous interest in the growing income and
some speculative guesses, information frictions, noise arising wealth inequalities in the AEs, well-articulated in the work of
from failure of proper signal extraction, etc. A number of efforts Nobel Prize winner Thomas Piketty (2014). The high unem-
were made under a class that is broadly known as rational ex- ployment rates since the outbreak of the global financial crisis
pectations models. Mankiw et al (2003) referred to the sticky and absence of fiscal stimulus owing to the fear of reaching
information model arising out of information frictions. The fric- debt unsustainability levels have created the inequalities.
tions arise because of infrequent updating of information sets Besides, rich asset holders are said to have benefited at the
partly owing to high fixed costs to acquire information sets. For expense of the poorer ones, who are largely dependent on in-
the noisy information models, Woodford (2003), Sims (2003), terest income. The question often asked is, what would happen
Mackowiak and Wiederholt (2011) and others do consider the to the “in-betweens,” such as, for example, the pensioners?
situation where agents update information continuously. But, In the case of the EDEs, the inequalities issue has been para-
because information is not easily observable, the updated infor- mount for a long number of years, as reflected in a number of
mation could carry beliefs about what may be considered as studies on poverty and the poor. Some of the EDEs that have
“underlying fundamentals” via a signal extraction problem. As not even attained the medium-income levels have taken to
a result, forecast errors across agents could arise. Both these inflation targeting as the framework of their monetary policy.
approaches require that surveys be undertaken regularly and Aggravation of inequalities in the EDEs would lead to politico-
revisions in information made continuously. social conflicts and throw up uncertainties in macroeconomic
Yet, these efforts have not resolved the problem of forecast policymaking and implementation of the frameworks in
errors in the empirics provided by these authors. Aggregating existence.
forecast revisions would still not remove the forecast errors. At
the individual level, the errors could be much higher.23 This is In Conclusion
why one probably may have to take the help of psychologists The issues raised in this paper need to be closely researched.
and behaviour economists to see whether forecast errors could More recently, the RBI and the IMF seem to have collaborated
be minimised to tolerable levels for the time horizons that one on working on a quarterly monetary model (Benes et al 2016a,
considers for purposes of formulating expectations in a 2016b). This augurs well since it would bring into open some of
relatively credible manner. the agreements and concerns about the issues raised here. If
Does determination of short-term interest rates help con- the collaboration is broadened in scope and if it helps improve
struct long-term interest rates? It is largely agreed that the theoretical basis and working of FIT, it would be most
short-term interest rates help influence money market rates helpful for those EDEs who would be contemplating the
and the structure of interest rates, also known as the yield adoption of FIT as their monetary policy framework. The effort
curve. There is also general agreement that long-term interest of the collaboration might also help the AEs revisit the working
rates should generally be such that investors would be enthused of their FIT framework and make necessary adjustments in the
to undertake new projects or for expansion of existing projects. conduct and implementation of monetary policy.
50 MARCH 25, 2017 vol liI no 12 EPW Economic & Political Weekly
 MONETARY POLICY

Notes or if interest rates are reduced by monetary au- bank’s commitment to control prices has to be
thorities for some reason, lending banks would consistent.
1 Duvvuri Subbarao’s remarks at the panel I of be under financial stress. Adverse selection by 18 One way of providing incentives is to adopt a
the “Governors Speak” moderated by Martin banks occurs essentially because of asymmet- contracting approach wherein an optimal con-
Wolf (quoted in Gokarn 2011). ric information. Raising of interest rates to re- tract would have to be set in place between the
2 The outside experts of Monetary Policy Com- duce losses from bad loans is not a solution in government as the principal and the central
mittee are: Pami Dua, Delhi School of Econo- an atmosphere of asymmetric information. bank as the agent. The contract would be for
mics, Delhi; Chetan Ghate, Indian Statistical Only rationing of loans would be most effective attaining a given objective. The central bank
Institute, New Delhi Centre; and Ravindra to address the problem (Stiglitz and Weiss would be faced with a penalty on an ex post
Dholakia, Indian Institute of Management, 1981; Akerloff 1970). basis if say the outcome is sharply different
Ahmedabad. The insider experts, apart from 11 The “too big to fail” argument did not work from the original planned target, unless there
Governor Urjit Patel, are Deputy Governor R during the global financial crisis. When the were factors that were beyond the control of
Gandhi and Executive Director in charge of sub-prime mortgage market failed, banks and the central bank (Walsh 1995).
Monetary Policy Department, Michael D Patra. investment banking firms exposed to the mar- 19 The threshold rate of inflation for optimal
The committee was constituted in September ket faced financial losses that could not have growth would not be a static number for years
2016 and the first monetary policy review of been redressed without official intervention. on. It should be worked once every three to
the committee took place on 4 October 2016. It On 15 September 2007, when a major invest- five years and set up for the medium-term peri-
is now expected that Gandhi would be replaced ment banking firm—Lehman Brothers Hold- od ahead. The threshold rate could be con-
by Viral Acharya when he takes over as deputy ings Incorporated, which not supported by the veyed in terms of a tolerable and credible band.
governor in charge of monetary policy. federal system then under the Chairmanship of 20 The Urjit Patel Committee report recommenda-
3 Ben Bernanke, Frederic Mishkin, Lars Sven- Ben Bernanke—had filed for bankruptcy, the tion, reached at the end of 2013, of realising 4%
sson, Adam Posen, and Mervyn King were financial crisis had reached a peak level with- at the end of the medium-term period is sur-
some of the well-known economists who advo- out any national borders. The federal reserve’s prisingly the same as the recommended infla-
cated in a steadfast manner inflation targeting defence was that supporting Lehman Brothers tion rate by the Chakravarty Committee of
as a framework of monetary policy. To this list would have meant a forbearance that would be 1985. Sukhamoy Chakravarty chaired a com-
of independent economists must be added gov- close to moral hazard. Many European econo- mittee at the request of the then Governor of
ernors and chief economists at the central mies including the United Kingdom, however, RBI Manmohan Singh, and its member, who
banks that have adopted inflation targeting as gave official support to financial institutions, was the then Deputy Governor in charge of
monetary policy framework. small as well as big, in order to assure deposi- economic research, C Rangarajan (RBI 1985).
4 C Rangarajan was a staunch supporter of mon- tors and others that the financial system is as- 21 A few articles did appear in financial dailies
etary targeting on the grounds that the de- sured to be stable. However, bailing out big and financial weeklies of India on inflation tar-
mand for money in India from the 1950s to the banks would require large amounts of funding, geting in India. The contents of these articles
end of the 1990s had been stable. He, however, and hence fostering and promoting large-sized and the questions raised here need to be more
conceded that where money demand is not sta- banks would have to proceed cautiously from closely researched.
ble, one may consider alternate policy frame- the point of view of financial stability (Barth
22 He argues that “the notion of real rate is not
works. et al 2012).
theoretically relevant for the study of micro- or
5 See the Monetary and Credit Policy Statement 12 Deposit insurance hardly provides an assur- macro-economic problems. It does not protect
of April 1998 by Bimal Jalan, Governor, RBI for ance of the safety of deposits. For example, in against potential losses of purchasing power
first signs of initiation of the move away from India, the maximum amount of individual de- and the underlying arbitrage is impossible to
monetary targeting to the eclectic multiple in- posits that are insured amounts to only do at the macroeconomic level” (Tymoigne
dicators approach (RBI 1998a). The announce- `1,00,000. This amounts hardly to $1,540 at, 2006: 2). He concludes by saying that “econom-
ment made a special mention of the evidence of say, $1=`65. ic agents are far more concerned” with nomi-
weakening of the stability in the demand for 13 Ben Bernanke, when he was Federal Reserve nal matters (financial power, or liquidity and
money. The rationale underlying the anno- chairman took the view that financial institu- solvency) than with the real problem (purchas-
uncement may be found in the report of the tions in acute stress should not be given official ing power).
Third Working Group on Money Supply under bail outs because that would present a moral 23 Forecast errors, if large, would erode the cred-
the chairmanship of Y V Reddy (RBI 1998b). hazard. He allowed the failure of Lehman ibility of central banks. If the forecasts are
6 Raghuram Rajan took an unprecedented step Brothers in 2007. He, however, enabled the made purely on expectations surveys, the cred-
of appointing on the day of his assumption as banks in stress to help themselves with actions ibility issue would assume a large proportion.
governor, RBI, a committee under the chair- that ensure that the institutions would ulti-
24 The yield curve could be a leading indicator of
manship of then Deputy Governor Urjit Patel, mately overcome the problems of liquidity
future prospects of the economy. The leading
shortage. This has led, though, to some kind of
to examine the applicability of inflation target- indicator should not, however, be taken as pro-
capital rationing in the sense that the docu-
ing as monetary policy framework. In his earli- viding predictability. The fact that the yield
ments for taking loans have become cumber-
er report on financial reforms, Rajan supported curve had been inverted in the last eight years
some, thereby nullifying the advantage that
inflation targeting (RBI 2014; Planning Com- shows that yield curve would be more of an in-
borrowers would have got due to low interest
mission 2008). formation variable than a leading indicator.
rates. This explains the reason why low inter-
7 Rajan’s explanation can be gleaned from his est rates have not given a kick-start to
many speeches as RBI governor. investment. References
8 This arrangement has been there in India since 14 See studies relating to threshold rate of infla-
the outbreak of the Asian economic crisis in tion such as Barro (1995), Khan and Senhadji Akerloff, G A (1970): “The Market for Lemons:
1998. (2000) and Espinoza et al (2010). Qualitative Uncertainty and Market Mecha-
9 In 2005 at the Jackson Hole, during the confer- nism,” Quarterly Journal of Economics, Vol 84,
15 Deepak Mohanty and others, however, felt that
ence convened by the Federal Reserve Bank of pp 488–500.
the threshold rate for India could well have
Kansas, a number of economists spoke of the been 4.0%–5.5%, using data from QI 1996–97 Bagehot, Walter (2006): Lombard Street, A Descrip-
impending financial stresses and strains. to QIII 2010–11 (Mohanty et al 2011). tion of the Money Market, Charleston: Biblioba-
Raghuram Rajan, then economic counsellor at zaar.
16 Every governor of RBI till Raghuram Rajan
the International Monetary Fund, expressed held in this view. Financial stability has be- Baker, Dean (2002): “The Run-up in House Prices:
his fears of the breakout of the financial crisis. come a very vital and critical element in gover- Is it Real or Is It Another Bubble?,” Centre for
One of the first writings on the housing finance nors’ thinking particularly from the time of the Economic and Policy Research, Washington
crisis was in 2002 (Baker 2002). Asian economic crisis in 1997 partly also be- DC.
10 Adverse selection occurs in the credit market cause financial development cannot proceed Barro, Robert (1995): “Inflation and Economic
when lenders (banks) provide funds to projects without having an appropriate regulatory Growth,” Bank of England Quarterly Bulletin,
that do not give assured viability, under the framework in place. Vol 35, No 2, pp 166–76.
hope that projects will succeed over time with 17 Dynamic inconsistency or time inconsistency Barth, James R, Apanard (Penny) Prabha and Phil-
some assumed or promised actions on the part may be explained thus: a policy would be time lip Swagel (2012): “Just How Big Is the Too-Big-
of borrowers. It could also occur when banks consistent if an action proposed to be taken at to-Fail Problem,” Journal of Banking Regula-
are not fully aware of the different risks that time t for time t+1 remains optimal for imple- tion, Vol 13, No 4, pp 265–99.
borrowers carry and provide funds at relatively mentation when t+1 arrives. The new informa- Bhoi B K and H K Behera (2016): “Potential Output
high interest rates in order to improve banks’ tion that central banks gets between period t Revisited,” Reserve Bank of India Working
profits or insist on collaterals, such as real es- and t+1 would still not make a difference to the Papers, WPS (DEPR), 05/2016, April.
tate, as a screening device to assess risks for optimal policy action that was planned to be del Rio, Pablo and Michael Howlet (2013): “Beyond
different loans. If values of collateral collapse taken at time t+1. In other words, the central the ‘Tinbergen Rule’ in Policy Design: Matching

Economic & Political Weekly EPW MARCH 25, 2017 vol liI no 12 51
MONETARY POLICY
Tools and Goals in Policy Portfolios,” Annual Mohanty, Deepak (2013): “Efficacy of Monetary Stiglitz, Joseph and A Weiss (1981): “Credit Ration-
Review of Policy Design, Vol 1, December, pp Rules in India,” Reserve Bank of India, Mum- ing in Markets with Imperfect Information,”
1–16. bai, March, www.rbi.org.in/docs/speeches/ American Economic Review, Vol 71, No 3,
Friedman, Benjamin (2008): “What Objectives for PDF /MDSES. pp 393–410.
Monetary Policy?,” Central Banks as Economic Mohanty, Deepak, A B Chakraborty, Abhiman Das Svensson, Lars (2010): “Inflation Targeting After
Institutions, Jean-Philippe Touffut (ed), Chel- and Joice John (2011): “Inflation Threshold in the Financial Crisis,” Challenges to Central
tenham: Edward Elgar. India: An Empirical Investigation,” Reserve Banking in the Context of Financial Crisis—The
Gokarn, Subir (ed) (2011): Challenges to Central Bank India Working Papers, WPS (DEPR) International Research Experience, Subir Gokarn
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International Research Experience, New Delhi/ Murray, Cameron K (2016): “The Mysterious Real tion/Reserve Bank of India.
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Goodhart, Charles A E (2010): “The Changing Role Piketty, Thomas (2014): Capital in the 21st Century, ence Series on Public Policy, Vol 39, pp 195–214.
of Central Banks,” Bank for International Set- Trans Arthur Goldhammer, Cambridge and Tinbergen, Jan (1952): On the Theory of Economic
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ICSSR Data Access Scheme for PhD Scholars

EPW Research Foundation
Applications are invited from PhD students in universities and colleges for one year access to EPWRF India Time Series
(EPWRF ITS) for use in their doctoral research. This is to promote Social Science Research through Online Time Series Data Services.

(i) Up to 50 PhD scholars will be given access to the EPWRF India Time Series for one year.
(ii) Only students outside the ICSSR institutes can apply.
(iii) PhD scholars can request access to any five of the following modules of their choice.

(1) National Accounts Statistics of India (9) Banking Statistics

(2) Domestic Product of States of India (10) Insurance
(3) Price Indices (11) Finances of the Government of India
(4) Agricultural Statistics (12) Finances of State Governments
(5) Annual Survey of Industries (13) Combined Government Finances
(6) Industrial Production Series (14) Power Sector
(7) External Sector (15) Health Statistics
(8) Financial Markets (16) Educational Statistics

The application form can be downloaded from our website and may be processed through the research guide/department. For
further details about the modules, interested candidates can access demo version after free registration. For further details, please
visit www.epwrfits.in.
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52 MARCH 25, 2017 vol liI no 12 EPW Economic & Political Weekly