Chairman Mario Bleijer, Professor Stephen G. Cecchetti,
Professor William H. Buiter, Dr Guillermo A. Calvo and fellow Governors,
It is my pleasure to join the symposium
and as desired by you, Mr. Chairman, offer initial informal comments on Professor
Cecchetti’s paper on ‘Sources of Central Banker’s Influence over the Economy’.
Professor Cecchetti first succinctly brings out the convergence of developments
regarding application of monetary theory to the practice of central banking
and second, poses three challenges to both academics and practitioners. I will
make some general observations on the convergence issue and later comment upon
the challenges. Of course, I shall draw upon India’s experience as appropriate.
In terms of objectives, it is true
that there is a convergence in the thinking of all central bankers towards a
primary objective such as price stability. It is useful to note that, more recently,
a strong trade-off between volatility in growth and inflation masks or understates
the equally important consideration of financial stability. In India, along
with price stability, growth objective is demonstrably subsumed in the objective
of meeting genuine credit demand and in communications and policy measures,
a clear focus on financial stability has assumed added significance in recent
years.
Secondly, I agree with the point
that the central banks have a better design than before and also gained a distinct
identity in the last two decades. But without satisfactory fiscal rules, implementation
of any monetary rule becomes difficult as also the autonomy or independence
of central banks and its accountability. It is mainly for political economy
reasons that the central banks in general attempt to focus sharply on a ‘single
objective’ or mandate. This is an arrangement for convenience and merely gives
a distinct identity to a central bank and serves as a basis for autonomy. In
India the fiscal dominance over monetary policy has come down with elimination
of automatic monetization of fiscal deficits in 1997 and effective this year,
withdrawal from participation in primary issuances of government securities.
In fact, Reserve Bank played an active and interactive role in designing fiscal
rules in view of their criticality for monetary policy. We provided technical
inputs and assistance to Government of India as well as States while considering
Fiscal Responsibility Legislations. The point of harmony between fisc and monetary
policy is, therefore, well taken and I would stress, on the basis of our experience
in India, the value of coordination between fiscal and monetary authorities
in matters of structural transformation, specially legislations relating to
the economy.
Thirdly, on the emphasis placed
upon the tool of short-term interest rate, the real interest rate is, in some
ways, an outcome of policy implementation in containing inflation expectations.
Shifts in inflation expectations are indeed the proximate cause of the changes
in the mean level of inflation and the policy makers do, therefore, focus on
maintaining credibility by carefully monitoring inflation expectations for any
indications that they are rising. This forward-looking approach has helped India
in bringing down inflation rates from over eight per cent to about four to five
per cent in recent years.
There is also a need to recognise
the importance of inflation perceptions. In other words, if the prices of commodities,
which are purchased frequently, rise, the perception of inflation would be different
from say, a rise in the price of television set. While recognizing the overlap,
the distinction between inflationary expectations and inflation perceptions
in the context of inflation policy is worth bearing in mind. For example, inflation
perceptions tend to harden if prices of frequently purchased goods increase.
There is an interesting issue here
on delicate distinction between monitoring and influencing inflation expectations
on the one hand and giving forward indication on the other. In practice, it
is a delicate task to make such distinction but it is critical to bear such
a distinction in policy-making and communication. As Governor Mervyn King eloquently
argued in his speech yesterday at the Lord Mayor’s banquet in the City, there
are dangers of a central bank trying to give forward guidance in this highly
uncertain world. Governor King said, "The Monetary Policy Committee
(MPC) reaches a new judgment each month, made afresh in the light of all the
new information about the prospects for inflation. We don’t decide in advance.
So trying to give direct hints on the path of interest rates over the next few
months risks deceiving financial markets into believing there are definite plans
for the next few months when no such plans exist".
In fact, the Fed announced a few
days ago that Chairman Ben Bernanke had established a sub-committee to examine
a number of communications issues. More generally, the appropriateness of a
central bank doing the thinking on course of markets for the market-participants
rather than allowing them to do it, is questionable and this was articulated
by Mr. Schioppa of European Central Bank a couple of years ago. It is not surprising
that almost all central bankers prefer to inform and to fall short of guiding.
The notable exception to this practice was the former Chairman Alan Greenspan
though his successor Mr. Ben Bernanke is clearly revisiting the approach, perhaps
for very valid reasons. Guidance on future course becomes far more difficult
when the policy rates of monetary authorities get closer to what appears to
be the relevant range of neutral interest rates. This is because the trade offs
get more acute, judgmental and contextual relative to a state when interest
rates are clearly farther from the range of possible neutral rates and the direction
of movement is fairly obvious to all. The challenge of communication gets more
daunting, if simultaneously, the inflation expectations are also under stress.
We, in India, prefer to provide
detailed information and share relevant analysis fully to influence expectations
but are hesitant to give firm inferences from analysis or forward guidance.
Fourthly, though the focus of central
banks is on short-term interest rate and the considerations weighing in a decision
on this instrument require in practice, monitoring and analysis of a host of
indicators, both external and domestic including expectations, perhaps even
in the inflation-targeting countries. We in India have switched to multiple
indicators approach. There are two issues that need to be noted here. Where
administered interest rates prevail, there are complications. There are also
often inexplicable disconnects between the short and the long term interest
rates – what Chairman Greenspan had referred to as ‘conundrum’.
Fifthly, financial stability considerations
may, in our view, require the use of interest rate tool, in conjunction with
other prudential measures. Some times, there could be even a trade-off between
raising the short-term interest rate and tightening of prudential norms if risks
are perceived to originate from certain segments of the market. The highly leveraged
lending operations in the backdrop of asset price bubbles, might require adjustments
in margins and risk-based capital requirements. In India, noticing the unusual
movements in several asset prices in recent years, we have been enhancing risk
weights and provisioning requirements by banks for certain categories of assets.
Coming to the specific issues,
since the focus of monetary policy is on influencing the ‘aggregate demand’,
at the macro level, the aggregates represent an amalgamation of different forces
in operation at the micro level, sometimes moving in different directions. For
instance, when the general price level increases, there could be sectors where
prices are coming down; the same is the case with employment, consumption, production
and investment. Therefore, the micro foundations of macroeconomic analysis would
not mean a one-to-one correspondence between the two. This relationship is somewhat
nebulous but very important and should be viewed seriously with its significance
as well as inherent limitations in mind.
Secondly, excessive leveraging
in any conditions of financial markets is a source of potential instability.
Since leveraging is influenced by the cost of financing, the decisions affecting
the cost and availability of credit do influence aggregate demand conditions.
Even if the source of financing is not bank funding, the interest rate conditions
in the market definitely influence the opportunity cost of even internal resources
of firms. The effectiveness of interest rate and exchange rate channels, no
doubt, depends upon the depth and vibrancy of the debt and foreign exchange
markets. In India, special efforts have, therefore, been made to develop these
markets so that the efficacy of the transmission channel improves. In general,
it may be held that in less developed financial markets, by using direct monetary
instruments in conjunction with market-based instruments, the overall policy
effectiveness can be improved.
Nominal rigidities arise in different
segments of the market due to a variety of factors: the existence of organised
and unorganised markets in parallel, tax regime, labour and income policies
and trade union strength, level of competition or market imperfections, etc.
For example, since nominal rigidities are high in less developed and relatively
imperfect and underdeveloped markets, it should not lead to a conclusion that
monetary policy is more effective under these conditions. Of course, in India
recent events in equity markets are not easily explicable and so we can appreciate
the comment that equity markets have a mind of their own.
As a group, the central bankers
could take some credit for little explicit indexation in recent periods. However,
the Indian conditions on indexations are worth noting. The indexation is available
only to workforce in the organised sector, which accounts for less than ten
per cent of the total workforce, and within that, mainly to those in the public
sector. Having secured the principle of indexation, it is not given up by the
organised work force, whatever be the level of inflation. No doubt, at the margin
or incrementally, there could be less pressure for indexation, but existing
privileges are not easy to be eliminated.
On the policy actions, under relatively
more stable economic environment, the need, the extent and the duration of the
policy interventions becomes less and less. Central banks are now taking baby
steps – sometimes more frequent steps and at other times after a long gap, and
in both directions – to respond to, what appear to be, ripples rather than huge
waves in the sea of economic activity. For instance, what is considered as a
‘neutral rate’ of interest in the present period appears to be much lower compared
to several years before.
The issue of significance here
is whether the neutral rate in respect of emerging market economies, which has
been coming down in tandem with global rates, will tend to be distinctly higher
than in developed economies. If so, how much higher would be appropriate?
Thank you.