Forward guidance loses steam in downward cycle: RBI's Deputy Governor Patra

Patra said that under heightened uncertainty, discretion in forward guidance has increasingly gained legitimacy among major central banks

Forward guidance by central banks during a rate-increase cycle may not be as effective as in a downward cycle, Reserve Bank of India (RBI)’s Deputy Governor Michael Patra said in a speech on monetary policy communication on Thursday. The speech, as part of RBI-organised “High-Level Policy Conference of Central Banks in the Global South”, was uploaded on the website on Friday.

 

“While the utility of forward guidance at very low policy rates is unambiguously proven, its efficacy at higher rates is questionable. This is consistent with the asymmetric nature of the monetary policy cycle — the way down has a lower bound, but the way up is technically unconstrained by any upper bound,” Patra said.

 

 

“Empirical evidence in the Indian context suggests that forward guidance in a policy-tightening cycle loses steam as the policy rate increases beyond a threshold,” he said.

 

After increasing the policy repo rate by 250 basis points (bps) between May 2022 and February 2023, the RBI has maintained a status quo. However, in the previous policy review in October, the stance of the policy was changed to neutral from withdrawal of accommodation. Market participants expect the interest rate direction to be downward, going forward.

 

Patra said under heightened uncertainty, discretion in forward guidance has increasingly gained legitimacy among major central banks. He further said that monetary policy framework and its communication need to reflect the inherent uncertainty in policymaking.

 

“…The optimal level of communication remains the gold standard for all central bankers — too much can create a ‘signal extraction problem’ while too little can keep the markets guessing,” he said.

 

Meanwhile, Patra also highlighted that while monetary policy needs to manage inflation expectations, micromanaging them may be counterproductive.

 

“In terms of targeting the audience, central banks are still learning how best to communicate with the wider public. It is said that communication is the bridge between confusion and clarity. Central banks must engage in constantly refining and upgrading this ‘soft skill’ to make it effective,” Patra said.

 

Unlike in advanced economies, in India, the RBI has refrained from providing forward guidance on policy rate but it outlined both time- and state-contingent forward guidance during the Covid-19 pandemic.

 

“During the policy-tightening cycle amidst heightened global uncertainty and overlapping shocks, the RBI was of the view that forward guidance itself could be a source of policy uncertainty, undermining policy credibility. Accordingly, it refrained from forward guidance in the policy-tightening cycle,” he said.

 

“Nonetheless, the RBI has emphasised on clarity in communication, while maintaining a balance between both high- and low-frequency communication of monetary policy,” Patra added.