RBI Deputy Governor Patra Explains What Slows Down Monetary Policy Transmission

The transmission of policy rates faces delays in India due to the structure of the financial market and frictions within its various segments, according to Reserve Bank of India Deputy Governor Michael Patra.

Monetary policy operates with long and variable lags, Patra said in his speech at the treasury heads seminar organised by the RBI on Tuesday. In normal times, a rate change takes up to one year for its peak impact on growth and up to two years for its peak impact on inflation, he said.

Many of these lags emanate from frictions in financial markets, especially at the synapses, Patra said, explaining what he called instances of "transmission and distribution losses" in the money, government securities, forex, and derivatives markets.

After the monetary policy action and stance gets seamlessly conveyed to the overnight market, the transmission progressively loses strength and sometimes direction as it meanders through the money market spectrum, he said. In recognition of these impediments, central banks are often persuaded to increase the size of their rate changes disproportionately in relation to the desired objective to ensure an adequate amount of transmission, but this can increase borrowing costs inordinately and result in an overkill of economic activity, Patra said.

For instance, the bulk of money market activity is concentrated in the overnight segment, which has become the money centre. Consequently, proceeding outwards on the term curve, are India’s missing markets—the segment between three days and three months, Patra explained.

While the RBI has stepped in with alternate measures, nothing can substitute for a term curve generated from actual transactions, he said.

The lament of monetary policy in India is that liquidity in the G-sec market is not uniform across the curve and concentrated in only on-the-run securities of five years, seven years, 10 years, and 14 years maturities, said Patra. Consequently, monetary policy signals are conveyed across the curve in a disjointed manner, reflecting time-varying liquidity premia with diminishing intensity as maturity increases, the RBI deputy governor said.

In the corporate bond market, which uses G-sec yields as benchmarks, only issuers of the highest quality find favour and, as a result, issuers with lower ratings depend on banks. Transmission to corporates across the entire spectrum of ratings, therefore, remains incomplete and/or delayed.

In times such as now, it pays for both, financial markets and the central banks, to share a common set of expectations, Patra said, after all, macroeconomic and financial stability involves shared benefits and high stakes for both.

The practice of changes in deposit rates preceding changes in lending rates and sticky margins have been prime impediments to monetary policy transmission, the deputy governor said.

A large and unanticipated change in the exchange rate can cause pass-through to become higher, with macroeconomic consequences since a third of the CPI consists of imported inflation, Patra said. Analogously, an exchange rate depreciation of 5% can benefit exports and squeeze imports, causing GDP to increase by 15 basis points, according to a central bank's findings. Currently, there is increasing evidence that corporates are experiencing pressures on profit margins due to exchange rate movements impacting input costs and debt servicing. This has financial stability implications which necessitates interventions in the forex market to insulate the market from spillovers, Patra said.

In extraordinary times such as now, it pays for both the financial markets and the central bank to share a common set of expectations, Patra said. "After all, macroeconomic and financial stability involves shared benefits and for both, high stakes."