Reforming the Monetary Policy

Monetary policy has become one of the most valuable tools for the administration and development of an economy. Its ability to control the money supply and influence interest rates has a far most influential reach than any other policy. One of the most significant reasons is that the time lag between implementation and result is the least among alternatives. Central bank policy reviews have become one of the most anticipated indicators, for both investors and general public alike.

The policy reviews provide and insight into the overall economic conditions and coming future central bank and government policy changes or tax alterations. The citizens eagerly wait for their newspapers to tell them if home loans are going to get cheaper, if the inflation is going to eat away their savings, is their neighbour going to buy a new car or a scooter, etc. On the other hand, businesses, foreign investors and economists get an analysis of the country’s current scenario and state of economy. Thus, that leads me to the point that how monetary policy has become a part of our daily affairs and that’s why it is so effectual.

However, with great power comes great responsibility. The central bank has to be more responsible about its  guiding principles. Thus, I feel the most significant facet of a central bank’s monetary policy is it’s objective. I say that because as we have seen in the past, different central banks set different objectives and so have varied approaches and of course giving diverse results. To keep it simple let me list down these broad objectives:

• Price stability or inflation targeting
• Economic growth and low unemployment

There has always existed a trade-off between these to policy objectives. Generally it is according to the history, social-political scenario or economic conditions of the country which configures the monetary policy planning.

The European Central Bank has its primary objective of monetary policy to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term. This conservative approach has been criticised by many to be neglecting growth and high unemployment. But, like I said there are social factors which influence as well. There are long memories of people in Europe specially Germany of hyperinflation. So they are sure to be conservative. On the other hand, USA’s fed follows a more aggressive policy of concentrating on economic growth. Although the fed has always claims to have been following a mixture of both.

What’s for the future?

This present crisis has exposed an unpalatable truth that the monetary policy has to be very dynamic and holistic in nature, in order to keep up with today’s ever-changing economic and international trade environment. A number of fresh approaches have come to light in the past one year.

One such is Macroprudential regulation. Financial stability was considered to be one of the ‘other’ objectives of the central bank. But, last year the banking crisis showed that we need better regulation of the system by the central bank which includes measuring cyclic macro prudential indicators and reviewing banks individually rather than setting just petty capital adequacy norms.

One of the other important roles of the central bank is the role of custodian of foreign exchange and maintaining reserves. This include policies targeting BOP surpluses and adjusting monetary policies keeping in mind the position of the current and capital account reserves. For some economies which have a fixed exchange rate system, this forex management forms a crux of the central bank policies. We could see central banks taking this up more seriously and making it one the core guiding principles, especially as globalisation has brought so many opportunities and equally challenging threats to domestic firms. Thus, it should get more attention then it presently gets.

Another interesting method is the multiple indicator approach with Reserve bank of India follows. It includes tracking a number of indicators on whose basis its monetary policy is drafted. I will discuss it at length in my next post.

As the world comes out of a difficult recession in many years, reform will not exclude the central banks as well. As an institution it has gained huge importance in our daily lives as well; and making it more robust, prudent and flexible should be the right way forward.