The key lesson that emerged from the collective soul-searching by the many central bankers who attended the RBI’s conference (Challenges to central banking in the wake of the financial crisis) in Mumbai last weekend is that yesterday’s heresies are fast becoming the new orthodoxy .For one, the financial crisis (that incidentally struck during a period of considerable price stability across economies) has shown that the narrow focus on inflation that underpinned monetary policy for more than a couple of decades does not necessarily guarantee financial stability. Policy-makers thus appear willing to jettison the minimalist “single-target single-instrument” approach of concentrating solely on checking headline inflation with variations in a short-term interest rate. The new orthodoxy demands constant vigil on a number of fronts and the nimble use of a variety of policy instruments. Thus, for example “prudential norms”, jargon for sector-specific intervention (changing capital adequacy or risk norms for instance) for bank lending in markets like mortgages and credit cards are likely to become as important as the policy interest rates that central banks set in their monetary policy meetings. For emerging markets like India, the new paradigm means that their monetary and financial policies are unlikely to be shaped by the cookie-cutter of the “developed market” model. The playing field of global financial transactions is likely to remain “un-level” and it is up to individual central banks and financial authorities to select what is best for them. Capital controls that agencies like the IMF had shunned for so long are no longer a taboo. Speaking on the sidelines of the conference, RBI Governor D Subbarao emphasised the need for both “active capital management” and reworking the capital account convertibility road map. The upshot is that the pace of integration of the domestic financial system with the international financial system will slow down in the coming years. International banks or investors cannot take unfettered access to the Indian markets for granted. RBI incidentally shot down the proposal to allow FIIs into the nascent currency futures market.
RBI has a natural advantage in operating within the new paradigm. A multiple instrument model of monetary policy is better suited to what Subbarao referred to as a “full service” central bank that has multiple remits of managing monetary policy, supervising banks and managing the government’s borrowing needs. This is unlike many other central banks that are responsible solely for monetary policy with the task of financial supervision or playing banker to government being entrusted to other agencies. However, an eclectic play-it-by-ear approach to monetary policy as opposed to a more mechanical approach based on an inflation-targeting rule has a potential downside. Eclecticism could become a euphemism for fuzziness about policy goals. The Indian bond markets have been on tenterhooks for the last few months, apparently puzzled by RBI’s reluctance to tame headline inflation with stricter monetary action. The absence of strictly defined monetary policy targets could also give fiscal authorities more opportunity to arm-twist the central bank into accommodating its fiscal excesses. This could lead to a permanent rise in inflation expectations and a permanent dent on the central bank’s credibility as an inflation-fighter. That is hardly desirable.
