Communication about its thinking on the future path of major economic variables including policy rates is an essential part of monetary policymaking. In the words of noted communication theorist Paul Watzlawick "You cannot not communicate”. The art and science of monetary policy have rapidly evolved over the past two decades as can be seen from the actions of major developed market central banks. Notably, the US Fed started its post-policy press conference only in 2011, three years after the global financial crisis which had caused a substantial change in the way developed market central banks’ conducted monetary policy.
During the course of this evolution and more importantly, the post-global financial crisis (GFC), “forward guidance” has become a central piece of central banks armour. The famous Dot Plot of the US Federal Open Market Committee (FOMC) contains estimates of the future path of Fed Funds rate by individual FOMC members. These have significant sway on the way markets think about the Fed’s future policy actions.
In the Indian context, the Monetary Policy Committee is a very recent phenomenon. Since inception, MPC has held 16 meetings over the course of two and a half years. It has adopted a wide set of tools in its communication namely: a) Resolution of MPC which includes a statement of current action and policy stance along with a summary of its assessment of economic conditions b) Press conference by the RBI governor along with deputy governors c) Analyst press conference d) Monetary policy report which is published twice a year and e) the minutes of MPC meeting which are published after 14 days of the meeting. However, Rate action on the day of the meeting and policy stance form the central piece of the policy in setting the market’s expectations.
However, a simple analysis of the policy stance and future rate actions reveals that the MPC has not been able to stick to its policy stance in subsequent meetings. This raises an important question about the efficacy of communicating the policy stance along with the rate action. Out of the 16 meetings that it held since formation, MPC decided to change rates six times. Four times it changed rates when the previous policy stance was neutral. Once it reduced the rate when the previous stance was tightening. Only in one case, the rate action was consistent with the previous stance. If we do a simple consistency scoring analysis whereby we give a score of +1 for a rate action consistent with the previous stance, -1 for rate action inconsistent with previous stance and 0 for a stance change with no rate action, we get a total score of ZERO over the course of this period. It is, therefore, hardly a surprise that the market players find MPCs rate actions inconsistent at times. Granted, this analysis is a very crude way of looking at things and we have a small data set from the statistical standpoint, it still underscores the need to re-evaluate the efficacy of policy stance.
Another related issue in the Indian context has been Systemic Liquidity management by RBI. Market players have often questioned the strategy of keeping the Systemic Liquidity in deficit mode even when the policy stance has been accommodative or neutral. Most players including this author will argue that in the Indian context, transmission of interest rate actions of MPC is better achieved through Liquidity actions rather than an explicit forward-looking policy stance.
A unique feature of our MPC construct is that while the committee takes rate actions, the management of liquidity conditions is left to the discretion of the RBI staff. In contrast, the US FOMC explicitly specifies the objectives of Open Market Operations which are conducted by Federal Reserve Banks on its behalf.
In order to bring the consistency between its rate actions, policy stance and liquidity management, it will be perhaps more useful to move to a system of announcing “today’s rate action + future liquidity management stance” instead of “today’s rate action + future policy stance”.
In the words of Jens Wiedmann, president of the Deutsche Bundesbank and chairman of the Board of Directors of the Bank for International Settlements: “Communication can also make monetary policy." The central tenet of monetary policy actions of any central bank is to affect future behaviour of economic agents. Communication about the likely future path of policy rates and other economic variables by the central bank affects the forward expectations. It is now deemed to be a more important and effective tool than the actual rate actions themselves.
Equally important is the aspect that the central bank needs to be seen as credible. In that sense, the stated policy stance of the central bank has to be reflected in its future actions. The track record of the MPC so far has not reinforced that belief. Hence, the MPC needs to re-look at the efficacy of its policy stance and perhaps needs to replace it with forward guidance on liquidity management. This will probably achieve much better transmission through the banking system and financial markets.
Neeraj Gambhir is a former banker and a money markets expert. This article is in response to Latha Venkatesh’s column