If one were to distinguish between the strategic and tactical styles in the conduct of monetary policy, then it can be said that Y V Reddy as the governor of the Reserve Bank of India will be a tactician rather than a strategist.
Most others, including the immediate predecessors, Bimal Jalan and C Rangarajan, have essentially been strategists.
The distinction is not only stylistic. It has operational implications. While a strategist aims at achieving final objectives, a tactician reflects more on short-run operations.
For effective tactical monetary management, one needs a set of policy instrument -- a whole set is already in place -- and an effective transmission mechanism. Reddy is acutely conscious of the fact that the financial markets in India are relatively underdeveloped and unintegrated, as a result of which policy actions are not being quickly transmitted.
This means two things: first, a blunting of the effectiveness of monetary policy and, second, that in such a situation, it is not possible for the central bank to signal its intention with one single instrument.In view of this, even as it will be on Reddy's agenda to improve the effectiveness of instruments through a better transmission mechanism, he will tactically rely on more than one instrument.
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So more than a reduction in interest rates per se, the focus will now be on making sure that the existing low levels of interest rates percolate down.
This kind of a tactical thrust is bound to have some implications on the overall strategy. From within the broad class of monetary strategies, Reddy is likely to follow a multiple indicator approach -- rates of return in different markets, movements in currency, credit, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in foreign exchange -- which does not have an explicit target.
Till now, because of the reasonable stability of the money demand function, the annual growth in broad money has been used as an intermediate target of the monetary policy. But with the rate channels gaining importance over the quantum channel and the output response to policy operating through the interest rate gaining in strength, this approach will probably go.
Reddy also does seem to believe that following globalisation, technological advancements and large movements of capital across national boundaries, conducting monetary policy with explicit intermediate targets will not work. Also, his view seems to be that in the framework of explicit strategy, the monetary authorities get limited in their discretion of policy goals.
In many ways, Reddy's stint at the RBI may actually prepare the system for a targeting-based policy. In a monetary targeting framework, one needs stability of the money multiplier; in an interest rate targeting framework, success depends upon the strength of the relationship between the short-term and the long-term interest rates.
Both these can be achieved with better conduct of operations, which is what his focus will be.
With a focus on operating procedures, the choice of the operating target becomes crucial since this variable is at the beginning of the monetary transmission process.
Here, he will have to build on some of his earlier work -- like changing the nature, extent and the frequency of different money market operations, the use and width of a corridor for market interest rates and the manner of signaling policy intentions -- that he did when he was the deputy governor at the Reserve Bank.
Even as it is certain that he will make monetary policy responsible for a number of objectives, financial stability will be right on top of the list. There are two reasons for this; first, his long-held belief that most of the severe economic downturns have been associated with financial instability.
And second, capital flows and liberalisation of financial markets have increased the potential risks of institutions, which brings the issue of financial stability to the fore.
This ties in pretty neatly with the expected focus of policy and operational changes, which, as we said above, will be on improving/controlling the transmission mechanism of monetary policy action on financial markets.
In trying to detect, control and assess the origin and the transmission of different types of shocks in the financial system, the challenge would be to work out a proper feedback in policy, which will in turn enhance the effectiveness of different policy instruments.
As far as relations with the government are concerned, Reddy is likely to press for a clearer demarcation of responsibilities and accountability between RBI and the government with an appropriate degree of transparency.
This could mean RBI finally divesting all ownership functions as also term-lending functions. He is most likely to see the government set up its own independent debt management outfit that takes over the present functions discharged by the RBI, and thus avoid conflict of interest in conduct of monetary policy.
It has been one of his favourite hobby horses and RBI in its annual monetary policy of 2001 had announced its intention of divesting itself of the debt management function. An enabling proposal to de-link the function of debt management of the government from the Reserve Bank has been made in the RBI (Amendment) Bill 2001.
If Reddy's track record at the RBI is anything to go by, information management will play a big role in his tactical management of monetary policy. While there will be an ongoing improvement in increasing transparency as the long-run strategic objective, RBI under Reddy will see some disclosure of the tactical considerations to influence the market.
He will surely make information management play a crucial role for short-run stabilisation.
Remember Goa? Don't be surprised if surveys get done to assess market expectations and use these as a major guidepost in formulating monetary tactics. As a part of this game, RBI may also disseminate the minutes of the meetings of major monetary policy decisions, which has been a long-standing demand.
All this will improve financial market's understanding of the conduct of monetary policy and thus reduce uncertainty -- something that is very close to Reddy's heart.
So, what are the three things, in terms of specific policy action, that one is most likely so see during the Reddy regime at the RBI?
First, there will be a reduction in the reserve ratio to such an extent that it will no longer be considered an active monetary instrument.
Second, an increase in the market orientation of RBI's instruments resulting in greater activism in liquidity management through indirect instruments.
Third, a greater focus on interest rates with the RBI concentrating on the very short end of the yield curve.
If this assessment is correct, then monetary policy under the new governor will have a short-term flavour to it: monetary policy actions geared towards financial markets are bound to have short-run implications.
RBI's monetary tactics will be designed, based on its assessment of the strength and weaknesses of the transmission mechanism.
Given that there is a considerable degree of uncertainty in the transmission channels, given that the financial markets are not yet developed, the times ahead will be quite interesting and exciting from a policy point of view.
Photo: Jewella C Miranda
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