A paradigm shift

The Centre’s decision to enter into a binding agreement with the Reserve Bank of India to make inflation control the centrepiece of monetary policy is arguably the most significant monetary policy reform undertaken in the past two decades of liberalisation. According to the Monetary Policy Framework Agreement, the central bank is now duty-bound to adjust its monetary policy in order to bring consumer price inflation under 6 per cent by January next year, and, from fiscal 2016-17 onwards, target a consumer inflation rate of 4 per cent, with a band of plus or minus 2 percentage points for all subsequent years. The agreement also states that the RBI would have “failed to meet the target” if inflation rises above 6 per cent for three consecutive quarters, starting next fiscal. The floor is equally important — the target would also be considered missed if inflation falls under 2 per cent for three consecutive quarters in any year. This marks a significant departure from the past, when the RBI’s policy stance was dictated by a number of factors, including growth prospects, the government’s borrowing levels, fluctuations in exchange rate and currency flows.

It also brings some certainty to the direction of monetary policy. The RBI is now required to publish its operating target and the means by which it intends to achieve it. Since both the destination and the route are known in advance, this will all but eliminate “policy shocks” for the markets. However, the degree of independence the central bank will enjoy may also depend on its actions. What, for instance, if the RBI were to say that the ‘repo’ rate would be hiked if the fiscal deficit crosses a certain level? The nature and composition of the proposed monetary policy framework committee is equally crucial. While the Urjit Patel Committee had recommended a five-member committee led by the RBI governor, with just one external member, the Srikrishna Committee has suggested an eight-member panel, with a government nominee and four external government-nominated members, thereby giving the Centre a much greater say in policy making.

The Centre would do well to carefully consider the implications before making its choice of committee, since an independent central bank is a must for inflation targeting to work. And while the RBI has been made responsible for any failure to meet the inflation target, the Centre has to do most of the work to ensure its success, since inflation in India is driven more by supply-side bottlenecks which it needs to fix. Making inflation the policy sheet anchor also increases the risk of exchange rate volatility. More importantly, unless the Centre reduces its fiscal deficit, and improves the quality of the deficit by controlling expenditure, inflation targeting will not work. This agreement will then go the way of the fiscal responsibility and budget management law, where pious intentions are more often than not trumped by political compulsions.

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