Forex Interventions Not Major Constraint On Monetary Policy Independence: RBI Study

There is a high degree of absorption of money supply impact arising from forex market interventions, and no major constraining influence of forex market interventions on the independence of monetary policy, according to the findings of a working paper by the RBI.

The paper, titled Monetary Policy Independence under a Flexible Exchange Rate Regime–The Indian Case assessment, explores if interventions in the forex market by the Reserve Bank of India continue to provide monetary independence or impinge on monetary independence.

It poses a macroeconomic challenge for policymakers where monetary policy independence, exchange rate stability and capital account openness cannot be achieved simultaneously.

In the age of international capital mobility, it is propounded that monetary policy independence can get constrained under a fixed exchange rate regime, even in the short run. However, under a flexible exchange rate regime, monetary policy is effective.

This basic framework has come to be known as the Mundell-Fleming model. The model has gained the popular term “impossible trinity” wherein macroeconomic management is challenged as monetary independence, fixed exchange rate and capital account openness are impossible to be achieved together.

Economies not opting for a fixed exchange rate regime have more control over their domestic monetary policy. While operating with a flexible exchange rate, India intervenes in the foreign exchange market to contain exchange rate volatility arising from surges and ebbs in capital flows.

Given that flexible exchange rates are expected to allow for monetary independence, the paper seeks to find whether India's exchange rate policy—under a flexible exchange rate regime with intervention to contain volatility—constrained monetary policy independence. With India's relatively open capital account, the trilemma boils down to whether the exchange rate is fixed or flexible.

The paper follows a two-step approach to find the impact of forex market intervention on monetary policy independence of India for the period between 1991 to 2020.

First, the level of sterilisation of excess reserve money from forex market interventions and its effectiveness in maintaining monetary policy independence is estimated.

Second, the paper estimates whether forex market interventions have an impact on the weighted average call money rate–the operating target of monetary policy in India.

The paper says that even during times of foreign exchange market intervention by the RBI, there has been low and stable inflation in India.

Evidence presented in the paper indicates that the RBI sterilises or absorbs a large proportion of excess money supply generated from forex market interventions.

Foreign exchange market intervention can be inflationary if the excess money supply beyond the absorption capacity of the economy is not adequately sterilised.

The results suggest that there is high degree of sterilisation of the increase in the money supply resulting from forex market interventions, but offsetting flows due to decline in net domestic assets and hardening of yields do not constrain monetary policy independence.

The study also finds that moderation in global risks leads to higher capital inflows into India. However, the consequent forex intervention to contain volatility of the INR and the resultant increase in money supply is neither inflationary nor elicits a policy rate response.