Comparing RBI’s monetary policy with Fed, Bank of England and ECB..

This is a wow speech from Deepak Mohanty of RBI. It is worth a Phd theses by itself..

The speech compares the operating framework of monetary policy of three top central banks with RBI.  We usually look at monetary policy as a policy which changes rates to manage inflation. That is surely the purpose but mechanics of implementing the policy differ vastly across central banks. This mechanics is called the operating framework which includes liquidity facilities, bank reserves, ways to change policy rates etc.  

This is an excellent table to sum up the speech showing differences in three major central banks with RBI:

Table: Key Features of Major Central Banks Operating Procedures

Features

Federal Reserve

ECB

BoE*

RBI

Policy Rate

Federal fund target rate

Main refinancing operations rate

Bank Rate

Repo Rate

Target rate

Federal funds

EONIA (Euro overnight index average)

Overnight market interest rate

Weighted average call rate

Reserve  requirements

0 to 10 % of transactions accounts, 0 for non-transactions accounts

2% on deposits with terms less than 2 years, 0 on longer term deposits

Optional with individual bank setting its own target.

6% of net demand and time liabilities of banks

Definition of 
Reserves

Balances at the Fed + vault cash

Balances at the ECB, excluding deposited funds

Balances at the BoE

Balances at the  RBI

Reserve maintenance
Period

Two weeks

One month

4-5 weeks

Two weeks

Reserve accounting

Lagged two weeks

Lagged one month

Reserve target set at least 2 days ahead of reserve maintenance period

Lagged two weeks

Standing Facilities

Lending (as of Jan 2003) Interest on reserves (as of Oct. 2008)

Both lending and deposit facilities

Both lending and deposit facilities

Both Lending (MSF and ECR) and deposit facility (collateralized reverse repo)

Open market operations

Daily, at market rate

Weekly, at the higher of the main refinancing rate or the market rate

Weekly and once in a maintenance period at the Bank rate.

Daily LAF auction at fixed rate. Long-term operations as and when required at market rate

MSF= Marginal Standing Facility; and ECR = Export Credit Refinance (available at repo rate up to 15 per cent of outstanding export credit); LAF= Liquidity Adjustment Facility.
* Since March 2009, BOE has suspended the reserve averaging regime and short-term open market operations on account of its asset purchases through creation of central bank reserves (known as quantitative easing).
Source: Adapted for advanced countries from Friedman B.M. and Kenneth N. Kuttner, Handbook of Monetary Economics, Vol.3B,North Holland, 2011.

Mohanty discusses in brief how India’s framework has changed over the years:

First, in the formative years during 1935-1950, the focus of monetary policy was to regulate the supply of and demand for credit in the economy through the Bank Rate, reserve requirements and OMO.

Second, during the development phase during 1951-1970, the need to support plan financing through accommodation of government deficit financing by the RBI began to significantly influence the conduct of monetary policy

Third, during 1971-90, the focus of monetary policy was on credit planning. However, the dominance of fiscal policy over monetary policy accentuated and continued through the 1980s. 

Fourth, the 1980s saw the adoption of monetary targeting framework based on the recommendations of Chakravarty Committee (1985). Under this framework, reserve money was used as operating target and broad money (M3) as an intermediate target. 

Fifth, structural reforms and financial liberalisation in the 1990s led to a shift in the financing paradigm for the government and commercial sectors with increasingly market-determined interest rates and exchange rate. By the second half of the 1990s, in its liquidity management operations, the RBI was able to move away from direct instruments to indirect market-based instruments. The CRR and SLR were brought down to 9.5 per cent and 25 per cent of NDTL of banks by 1997.

Sixth, the monetary policy operating procedure also underwent a change following the recommendation of Narasimham Committee II (1998). The RBI introduced the Interim Liquidity Adjustment Facility (ILAF) in April 1999, under which liquidity injection was done at the Bank Rate and liquidity absorption was through fixed reverse repo rate.

Recently, RBI changed the framework to a single repo  rate with call rate as the target.

Against this background, the new operating procedure retained the essential features of the LAF framework with the following key modifications.

First, the weighted average overnight call money rate was explicitly recognised as the operating target of monetary policy. Second, the repo rate was made the only one independently varying policy rate. Third, a new Marginal Standing Facility (MSF) was instituted under which scheduled commercial banks (SCBs) could borrow overnight at their discretion up to one per cent of  their respective NDTL at 100 basis points above the repo rate. Fourth, the revised corridor was defined with a fixed width of 200 basis points. The repo rate was placed in the middle of the corridor, with the reverse repo rate 100 basis points below it and the MSF rate 100 basis points above it. The current operating framework is illustrated in Chart 1.

Mohanty says the new framework has bought RBI policy in line with global benchmarks:

The new operating procedure improves upon the earlier LAF framework by removing some of the major drawbacks. It is also a move towards international best practices. It is expected that the new procedure will improve the implementation and transmission of monetary policy. First, explicit announcement of an operating target makes it clear to the market participants about the desired policy impact. Second, a single policy rate removes the confusion arising out of policy rate alternating between the repo and the reverse repo rates. It also improves the accuracy of signalling monetary policy stance. Third, the institution of MSF provides a safety valve against unanticipated liquidity shocks. It will help stabilise the overnight interest rate around the repo rate, particularly during deficit liquidity situation. Fourth, a fixed interest rate corridor set by MSF rate and reverse repo rate, by reducing uncertainty and avoiding communication difficulties associated with a variable corridor, will help keep the overnight average call money rate close to the repo rate.

As RBI has raised policy rates, how is the transmission so far? He points when liquidity in deficit, transmission working better:

The new operating framework with the modified LAF presupposes the dominance of the interest rate channel of monetary transmission. This means that once the RBI changes policy repo rate, it should immediately impact the overnight interest rate which is the operational rate and then transmit through the term structure of interest rates as well as bank lending rates. However, there are challenges. The strength of transmission through the interest rate channel depends on several factors, particularly on liquidity conditions. Recent experience suggests that as long as systemic liquidity was in surplus, the transmission of policy signal was weak. But once systemic liquidity turned into deficit, the response of the overnight call rate to policy rate was stronger .

He points transmission has been stronger in call markets (money markets), which has led to higher rates in G-sec (govt. securities) as well. However on credit markets it is much more complex as it depends on cost of deposits and demand for credit. It transmits with a lag in credit markets.

In the end he points to challenges for this new framework. Even when there is surplus liquidity in case of rise in Foreign inflows, RBI should maintain deficit liquidity using MSS bonds and CRR.

Superb stuff from Mohanty..

 

 

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