Abheek Barua: The cost of shock and awe

The Liquidity Adjustment Facility has to be revived as the single and sacrosanct signalling device.

Fed Chairman Ben Bernanke's first significant policy move of cutting the target Fed Funds rate by half a percentage point on September 20 saw a very important shift in style from that of his predecessor Alan Greenspan. Bernanke kept the markets guessing about the magnitude of the rate reduction till the very last moment and the cut took quite a few by surprise. I heard a somewhat excitable television reporter describe the measure as "shock and awe", a phrase coined to describe the relentless and spectacular bombing of Baghdad in the Second Gulf War of 2003. In the Greenspan regime, the Fed would have sent enough signals to the markets to sensitise them about the rate action. When the policy was announced, it would be entirely anticipated by the financial markets.

Bernanke could just be resurrecting an old tradition of policy-making in which the effectiveness of monetary action hinges on economic agents not being able to anticipate the action. The conventional logic behind retaining an element of surprise is simple "" if a certain policy is perfectly anticipated its impact is "priced" into the markets much ahead of the actual move. The policy, when announced, loses its bite.

More recent analyses point to the fact that fully anticipated policy gestures lead to mispricing risk. As RBI Deputy Governor Rakesh Mohan pointed out in a recent speech in Mumbai, "[y]et another view is that the repeated assurances of stability and guidance to markets about the future path of interest rates, coupled with the availability of ample liquidity, was an invitation to markets to underprice risks. This view, consequently, puts the blame on those central banks who failed to give space to markets to assess risks by eschewing surprise elements in policy". The RBI has, incidentally, in the past few years stuck to the "shock and awe" style all through, preferring to keep market players guessing about the direction of policy till the announcement.

However, this approach to monetary policy (let's call it the "surprise style", for convenience) is not entirely without its problems. My friends at various bank treasuries say that the extreme uncertainty regarding the RBI's actions has been a factor in keeping the overall cost of funds in the economy high by forcing them to pay an "uncertainty premium" for deposits. Let me explain this a bit.

Despite a sharp increase in liquidity over the last four or five months, deposit rates have not come down proportionately. This, in turn, has limited the extent to which lending rates have reduced, despite the fact that there is enough cash sloshing around in the system on the back of sluggish growth. Some bankers attribute this to the extreme uncertainty about the way the central bank conducts its monetary policy. It could suddenly step in and wring the system dry of all liquidity, as it did in December 2006 and February 2007, by hiking the cash reserve ratio (CRR) by a cumulative one percentage point over these two months. For a period in March, cash-short banks were forced to borrow at rates that were way higher than the refinance or repo rate.

These banks now find it sensible to keep their deposit rates high and pay a premium to insure themselves against a volatile policy regime. The idea is to build a war chest of funds to guard against an unexpected liquidity squeeze. The result "" the economy gets caught in a high-interest-rate equilibrium. (I must point out here, however, that this uncertainty premium is not the only explanation for sticky lending and borrowing rates.)

Both the proponents of the "surprise style" and the edgy bankers appear to have valid arguments and the best way to conduct monetary policy has to be somewhere in between. One of the reasons, perhaps, why bankers appear so perturbed about the unpredictability of policy is the use of multiple instruments in managing the monetary environment. We now have the CRR, the repo and reverse repo rates, as well as the market stabilisation scheme bonds as monetary policy instruments. To add to this, we have seen a temporary cap on reverse repo balances for banks. The use of MSS bonds has at times been haphazard. There have been phases, for instance, of extremely high liquidity crying out almost for MSS bond issuance but the RBI, somewhat inexplicably, has refused to respond.

One way to reduce the uncertainty about the policy environment without taking the "surprise" element away altogether would be to revert to a system where the Liquidity Adjustment Facility, or the LAF (the corridor flanked by the repo and reverse repo rates), and the MSS are the only instruments of liquidity management and policy signalling. Indeed, some bankers would be comfortable with just a signal policy rate (say, the repo rate) and a contingent instrument like the MSS. I have some reservations about the efficacy of a single policy rate in the Indian funds market, which sees some phases of shortage but is in surplus most of the time. Developed markets, where single rates work effectively, are typically liquidity-short most of the time. That said, the LAF has to be revived as the single and sacrosanct signalling device. Ad hoc temporary measures are best avoided and the contingent instrument, the MSS, in our case has to be used more systematically. In short, the element of surprise has to be limited to the future levels of the LAF corridor.

I am aware that the quasi-fiscal costs of conventional sterilisation are higher than the use of a blunt costless instrument like the CRR. I am, however, not entirely convinced by it. For one, the cost of sterilisation is relatively small in the broader scheme of things. The use of the reserve ratio, which entails direct impounding of banks' resources, could, on the other hand, lead to mis-pricing and misallocation of resources. The costs of this misallocation could turn out to be crippling in the long term.

The author is chief economist, HDFC Bank. The views here are personal