The monetary condition index (MCI) is a combination of rate variables, which helps countries in managing liquidity within the overall framework of monetary policy. It is a weighted sum of the changes in the short-term interest rates and exchange rate relative to a base period.

The weights, which are determined by econometric models, are reflective of the importance of the respective variables in influencing the target macro (dependent) variable. More open the economy is--as captured in the openness ratio--more will be the weightage to the exchange rate.

The Reserve Bank of India (RBI) has also been harping on the tune lately that the M3-GDP relationship is increasingly becoming confusing and interest rates have wider influence ondemand for money today than it was in the past. Given the increased influence of foreign inflow on domestic liquidity, a combination of short-term money market and the FX market rates may be though of to track the development of domestic market liquidity.

Some of the countries where MCI is used are New Zealand (inflation target), Canada (operating target) and Sweden (leading indicator). The respective weights are determined by central banks from econometric modelling. The respective weights are determined by central banks from econometric modelling. The exchange rate is found to be half as important in New Zealand and one-third as important in Canada, compared with the domestic short-term interest rates.

Given all the advantages of having this indicator, the concept is criticised on its analytical foundation, as the interest rate is exogenous, while the exchange rate is endogenous, so cannot be used as a substitute. It is hard to believe that resorting to an MCI target will make the task of the centralbank easier. It will also not help in removing policy uncertainties among the economic agents. MCI remains as one of the considerations of the central bank and the focus often shifts from MCI to one or more specific macro variables.

To that extent, the MCI adds to the list of confusion. Since the MCI is based on fixed co-efficients and the relationship between the underlying variables need not be constant, there is a risk of policy derailment.

Can one construct and use an MCI in the Indian context for monetary policy? Unlikely, primarily because of the technical difficulty. Different markets in India suffer from lack of breadth and depth, which result in absence of high-frequency price and volume data.

The RBI's monetary policy primarily works on the twin objectives of price stability and growth. The MCI could be a leading indicator for inflation. However, the impact of domestic interest rates and FX rates on domestic inflation will be further complicated by global growth and commodity price cycles andonce again by the policy spikes. Besides such an MCI will imbibe specification errors, since there are various other variables that affect domestic inflation; often it may purely be a supply side or a structural problem.

Let me pronounce a `Philip's Critique' that the MCI is not going to work. Since growth figures are not readily available--GDP growth is an annual figure and comes with considerable lag and even industrial production data comes with a two-month lag--construction of an MCI to track growth is not practical, given that the RBI's monetary policy primarily works on the twin objectives of price stability and growth.

To that extent, it is necessary to ensure that there is enough domestic liquidity. The central bank can use an MCI constructed out of short-term money-market rates and the FX market forward rates to track domestic liquidity developments. An MCI can be constructed to develop a leading indicator of domestic liquidity. However, domestic liquidity itself is difficult to define.

Onecould use the refined definition of monetary aggregates (L1 to L2) prescribed by the RBI working group headed by YV Reddy. The past few years' data can be used to determine the relative importance of domestic rates vis-a-vis the FX rates to construct an MCI that can serve as a leading indicator for domestic liquidity. It is, however, not necessary that there will be a leading indicator for domestic liquidity.

Given the fact that the domestic money and FX markets have seen numerous spikes driven by policy moves, an MCI (supposed to be a policy instrument) constructed using such data will end up being a leading indicator of possible policy moves by the RBI. Hence the MCI so constructed has to filter off the policy distortions to make any sense. Given all this, the development of a meaningful MCI for the Indian context will be a challenging task for the RBI.