RBI and inflation targeting: who is to bell the cat?

Inflation targeting is back in the news. Simply put, it means entrusting the central bank of the country — the Reserve Bank of India in this case — the job of maintaining price stability. In practice, the RBI would be called upon to maintain inflation within a pre-determined, well publicised range. Other objectives such as furthering growth obviously matter, but price stability will be the focus.

The Government has an important role in inflation management. While the monetary policy’s role in combating inflation is well recognised, it becomes far more difficult to demarcate the respective roles of the Government, and the RBI questions such as who will fix the inflation target and on what anchors — reference points — will the exercise be based cannot be easily answered, ignoring fundamental issues such as central bank autonomy.

Political dimensions will surface

It is inevitable that the political dimensions — the relationship between the Finance Minister and the RBI Governor — will surface. In fact, at the time of the recent RBI monetary policy statement, an undercurrent of differences between the two on whether there should be a rate cut or not is perceived (whether true or not).

Growth versus inflation control has been a traditional monetary policy dilemma, and it so happens that at the present juncture, the RBI is seen to be firmly focussed on inflation even ignoring — as its critics say — the requirements of the real economy. Inflation targeting has become highly topical after the RBI-appointed Urjit Patel committee submitted its report in January. In its key recommendations, the panel recommended inflation targeting to be formally accepted. In India, the Consumer Price Index-based inflation (retail inflation) will replace the Wholesale Price Index-based inflation as the policy anchor. The monetary policy committee will be given the mandate to maintain the level around a specific range. The RBI will be accountable for achieving this. While some parts of the Patel committee report have been accepted — the CPI inflation has become the policy anchor — there is a lot of controversy on who would fix the inflation target. Should the RBI be given complete freedom to fix and achieve the target? In which case what role does the government have?

Even before the report’s key recommendations were accepted, the RBI has gone ahead and fixed the target range for inflation — 8 per cent by January, 2015, and 6 per cent by January, 2016. The eventual target will be plus/minus 4 per cent. Significantly even though retail inflation has fallen sharply, the RBI has not budged from its position of a no interest rate cut. In September, retail inflation came down to its lowest since the composite Consumer Price Index was constituted in January, 2012. Falling food prices were mainly responsible. Yet, the RBI persevering with the status quo is to be seen in the context of possible supply-side shocks and food prices shooting up again due to poor monsoons.

Government’s misgivings

The government has not been happy with the thrust of the Patel committee’s recommendations. Back in January when the report was published, a senior government spokesperson had expressed displeasure over some key recommendations. For instance, targeting CPI inflation would mean higher policy rates for a longer period (this, of course, was much before the fall). Further, the CPI is imperfect. The large weightage given to food items would mean that structural and supply side issues need to be addressed. These are not usually dealt with by monetary policy.

In reply to this, the argument is that the RBI has an important role. Well entrenched inflation expectations may lead to higher wage settlements causing demand side pressures. Arguably, the most contentious point is in the composition of the monetary policy committee, which will (among others) be the focal point in the battle against inflation.

Hitherto, it has been the Governor who determines the rates after considering the views of the central bank’s technical committee. The Patel panel proposed a monetary policy committee (MPC) with three internal members — the Governor, the Deputy Governor and the executive director in-charge of monetary policy as well as two full-time members to be appointed by the RBI. If the committee had its way, the RBI’s control over monetary policy would be total. Not surprisingly, it is this last point which is at the crux of differences between the government and the RBI.

New equations

Unconfirmed reports speak of Finance Minister Arun Jaitley deciding on an eight-member MPC with five external members, whose names would be cleared by the RBI. Most importantly, the inflation target will be set by the Government or be cleared by it. All these would mean reduced autonomy for the RBI. The desirability of these moves would depend on the new equations that will come about between the Finance Minister and the RBI Governor.

So far, the NDA government has been extremely circumspect in voicing its opinions on things such as rate cuts. This has been in sharp contrast to the UPA period. A fundamental question is whether inflation targeting — vital as it is — should be the cause for crimping a well-earned central bank autonomy. The point also needs to be made that given the onerous nature of the task of maintaining price stability and the huge responsibility cast on whoever is going to fix the target rate, should the RBI take on the role enthusiastically? Elections have been lost in the wake of a price rise.

(This article first appeared in The Hindu dated December 15, 2014)

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