Unconventional monetary policy, which includes measures such as quantitative easing, forward guidance, operation twist, and widening of collaterals for central bank accommodation, was experimented by many central banks of developed countries during the global financial crisis.

A few emerging market economies also followed suit to prevent spillover of the GFC and support growth.

Limited success

During the ‘Great Moderation’, accommodative monetary policy pursued for a long period led to underpricing of risks. This exposed the global economy to asset price bubbles and finally led to the global financial crisis (GFC). Unconventional monetary policy (UMP) is ultra-accommodative and is typically pursued when monetary policy transmission breaks down completely due to ‘zero lower bound’ of the policy rate.

Many leading economists believe that UMP has had limited success so far. At best, it prevented the global economy from slipping into the 1930s-type Great Depression.

The UMP did have many unintended side-effects. First, it could not revive credit growth due to the extreme risk-averse behaviour of banks and financial institutions after the GFC. Second, bulk of the high-powered money pumped into the economy by major central banks returned to their balance sheets as reserves. The balance sheet size of the US Fed, which was around $800 billion before the GFC, surged to about $2 trillion by December 2008 and to more than $ 4 trillion by 2013.

Third, despite unprecedented injection of primary liquidity, commodity prices did not increase due to fall in income/consumption around the world. Fourth, asset prices recovered quickly, mainly in developed countries, to the pre-crisis level — a situation no different from the ‘irrational exuberance’ prevailing before the GFC. Many economists interpret this as central-bank propelled asset price bubble due to quantitative easing.

Fifth, part of the easy money of developed countries, which crossed boarders, created asset price inflation in many emerging market economies (EMEs). Sixth, the UMP could not revive global growth for a pretty long period despite real interest rates moving into negative territory in many developed countries.

As the limitations of UMP were widely felt, normalisation process, led by the US Fed, was initiated in many developed countries since December 2015. Before the monetary policy was fully normalised, global growth faltered again forcing many central banks of developed countries to abandon the normalisation process.

Central banks seem to have entered into a self-made trap, a result of pursuing easy monetary policy and, thereby, contributing to financial instability globally. They are committing the same mistake of pursuing an ultra-accommodative monetary policy they followed during the Great Moderation.

Many central banks are now seeking a wider mandate of financial stability besides price stability. Although central banks can play a key role in ensuring financial stability, the jury is still out on whether it an appropriate monetary policy objective.

The instruments used to achieve this objective primarily relate to prudential regulation and supervision of banks and the non-bank segments of the financial system.

As regulation and supervision are fiduciary activities of a central bank, sometimes performed by other agencies/regulators in many jurisdictions, central banks may not be able to achieve the wider mandate of financial stability without coordination among other regulators.

RBI’s experiment

The RBI has entered into a phase of UMP, much before reaching the ‘zero lower bound’ of the policy rate. Mention may be made about the large amount of forex swap, long-term repo operations (one to three years’ lending outside the conventional short-term liquidity management), and liquidity neutral ‘operation twist’ (purchase of long-term G-Secs fully offset by sale of short-term treasury bills and dated securities) to influence long-term yield without cutting the policy rate.

Besides, there is the regulatory forbearance, knocking out certain incremental assets, such as lending to infrastructure, real estate/housing, etc., from liabilities on which CRR is maintained.

Moreover, efforts have been made recently to quicken the pace of monetary policy transmission by asking banks to adopt external benchmarks for loan pricing. As these benchmarks, constructed by FBIL (Financial Benchmark India Private Ltd), are yet to stabilise, banks have started linking their prime lending rate to the policy repo rate, which is essentially a signalling rate decided by the MPC, not a market determined external benchmark.

There has been some moderation of lending rate; the weighted average lending rate has, however, fallen only by a few basis points. Banks continue to be extremely risk-averse, as they are yet to come out of the NPA (non-performing asset) mess.

Corporate sector balance sheets, particularly relating to big industries, continue to remain in de-leveraging mode. The demand for credit by start-ups and MSMEs is unlikely to make good the sluggish credit demand by large industries. Hence the fallout of the RBI’s UMP has been large expansion of its balance sheet due to unprecedented build-up of reverse repo on a daily basis.

Interest rate differential between India and the developed countries is still attractive despite five consecutive reductions in repo rate. This is attracting a lot of short-term money into India’s capital market, sometimes in the guise of foreign direct investment through different channels.

Status quo on repo rate for a while is fine due to inflation uncertainty. However, the optimal choice of monetary policy would be to reduce the policy rate rather than follow UMP for a long period, as India’s CPI inflation is expected to moderate and remain within the tolerable limit.

The RBI can nudge banks to shed unusual risk-averse behaviour. Following amendment of the RBI Act, a deposit facility at pre-announced interest rate has been enabled. It is time such a deposit facility offering low rates, say around 2.5 per cent, was introduced rather than pay attractive rates on the large reverse repo deposits of banks on a daily basis.

The writer is a Visiting Fellow at IGIDR and former Principal Adviser and Head of the Monetary Policy Department, RBI