Monetary policymaking

Forget the finance ministries of the world, the new power centers are the boardrooms of the Central Banks. Like Kremlin watching during the Cold War, scrutinizing and analyzing every move of these Central Banks and their powerful Chairmen have become the latest fad. Every statement is dissected and vivisected to glean out some underlying message about the policy trends of these Banks. Based on these perceptions, the financial markets and following them the economy at large, form expectations about the future monetary policy actions. And in an increasingly complex and integrated global financial markets, where market sentiment and confidence is of critical importance, the importance of expectations cannot be over-emphasized.

On 29th January, 2008, the Reserve Bank of India (RBI) came out with the annual credit policy review and on 30th January, 2008, the Federal Open Market Committee (FOMC) of the US Federal Reserve had its regular periodic meeting. Both these pre-designated events are forums where the RBI and the Fed are expected to announce the latest interest rates. Predictably, both were preceeded by massive and frenzied media speculation, flying in all directions, about the possible interest rate decisions. The speculative excesses, focussed on the decision expected to be taken on a fixed day and time, had started a good 2-3 weeks ahead. It also generated a whole spectrum of expectations among the market participants, revolving around the likely consequences of whatever decision was taken. It may not be incorrect to even claim that the market had travelled well in advance of the decision.

In many respects, it can be argued that the market speculation had foreclosed the options available before the Fed. For example, following the un-scheduled and dramatic 75 basis points cut of the Federal Funds rate by the Fed on 22 January, 2008, the markets had jumped to the conclusion that come the FOMC meeting on 30th, January, another 50 basis points cut was inevitable. These expectations effectively tied the Fed's hands. If contrary to the market expectations, it did not lower rates by 50 basis points, the markets would in all probability have reacted negatively. The financial markets had already betted so heavily in favor of a 50 points rate cut, that any other alternative would have triggered off a crisis.

Further, by providing the build-up time, the Fed may have even defeated many of its own objectives. In times of a liquidity and solvency crisis, one of the important objectives of monetary policy is to provide some time-cushion for the affected market participants to get their balance sheets into some semblance of order. However, speculative excesses that invariably get formed during the build-up time may outweigh the likely benefits of any monetary easing. The FOMC meeting on January 30, provided an anchor for the market to pre-empt the Fed, thereby reduce the impact of the January 30th rate cut and also effectively present a fait accompli to the Fed. Instead of providing cushion-time, it becomes an opportunity for more speculation.

Any policy decision, more so the monetary policy, will achieve its desired objectives only if the market reacts to it. If on the contrary, the market is allowed to form expectations of such decisions, which in turn determines the policy itself, then we have the recipe for bad policy making. While the present dispensation of announcing interest rate changes may have been suitable previously, it no longer appears the most ideal way of announcing interest rate decisions.

In light of the aforementioned, a few questions are in order. Has monetary policy emerged to such pre-eminence as to over-ride all other macro-economic policy levers? Are interest rates, such a critical macroeconomic variable, to the near total exclusion of all others? If yes, is this a desirable or healthy outcome? Given the extremely volatile and fluid nature of the global financial markets, are fixed and pre-specified meetings like the FOMC or annual credit policy statements, the appropriate forums to announce interest rate decisions? Does it not leave the Central Banks vulnerable to being pre-empted by the financial markets? Are we not experiencing an increasingly media dictated monetary policy? Is all the media attention and speculation surrounding interest rate reviews good for monetary policy? Or is the "wisdom of the crowds" beneficial in arriving at the right interest rates? Is interest rates driving inflationary expectations or the other way round?

In any case, I am convinced that like Sun Tzu's description of a good general, "An effective Central Bank should be felt and not seen!"