India’s inflation targeting framework needs a relook

It is widely accepted that the colonial hangover on Indian intellectuals is deep. Noting the performance of the Western world since the Industrial Revolution, and even after decolonisation, they are naturally enthralled by the Western intellectual world. This tendency is strengthened because most of the Indian establishment is a part of and shares in the perks of the West. That is why, even under a Swadeshi-type government under Prime Minister Narendra Modi, the macro-economic management of the country continues to follow the Western paradigm (as summarised in Washington Consensus) for monetary and fiscal management. The RBI framework on inflation targeting is an example of continued copying of the Western practices by our financial establishment.

Unfortunately, under India’s conditions, these frameworks are a serious hindrance to achieving India’s goals of rapid growth and employment generation. They are also not conducive to success of the Prime Minister’s 100+ schemes which follow the paradigm of Sabka Saath, Sabka Vikas , with particular focus on the welfare of the underprivileged and the deprived.

Given India’s current conditions and stage of development, the implicit and explicit assumptions underlying Chapter III-F of the RBI Act are not valid and have become a hindrance to the achievement of India’s development goals, and this Chapter should be scrapped through an ordinance.

Inflation control provisions

In the RBI Act of 2016, the chapter on monetary policy starts with the statement: “Provisions of this Chapter to override other provisions of Act. The provisions of this Chapter shall have effect, notwithstanding anything inconsistent therewith contained in any other provisions of this Act.” This creates strong incentives and obligations for the bank to focus on controlling inflation (which is the focus of the chapter) without adequate concern about other features of the economy, such as external value of the rupee, investment, financial stability, growth or employment in the economy, which are extremely important for India at present.

This provision also does not take into account the fact that for all these objectives, including inflation control, the RBI is not the sole or even the principal actor and has to work as a member of the team of institutions managing the macro-economic policy of India.

The Act goes on to mention: “The Central Government shall, in consultation with the Bank, determine the inflation target in terms of the Consumer Price Index, once in every five years.”

This gives predominance to the CPI in defining inflation. In India, other indicators of inflation such as the Wholesale Price Index are important for export performance. Inflation in wages in relation to the productivity of labour may also be highly important for determining the competitiveness of the India economy. Thus, several indicators of inflation have to be considered to for deciding on the impact of inflation on the economy, and not just the CPI.

The Act goes on to say: “The Monetary Policy Committee shall determine the Policy Rate required to achieve the inflation target. The decision of the Monetary Policy Committee shall be binding on the Bank.”

This implicitly assumes that the policy rate can determine the inflation rate. But in India, experience shows a weak link between the repo rate and the CPI. This is due to numerous factors: inadequate transmission of the repo rate, importance of externally determined prices such as food prices and fuel prices, and the role of administered prices such as wages and salaries as per the Pay Commission.

Moreover, it is also not appropriate that an unelected body such as MPC should have the final say in the matter of determining such an important policy measure as policy rates. Its role should, at best, be of an advisory to the Cabinet Committee on economic affairs.

The Act provides for action in case of failure to maintain the inflation target. To quote: “Where the Bank fails to meet the inflation target, it shall set out in a report to the Central Government–– (a) the reasons for failure to achieve the inflation target; (b) remedial actions proposed to be taken by the Bank; and (c) an estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions.”

This creates incentives for the MPC to err on the side of a high policy rate to control inflation, irrespective of its consequences for other factors such as investment rate or growth or employment. The MPC would also be biased on the side of appreciation in the real effective exchange rate, because of the possible one-time adverse effect of depreciation in the exchange rate on inflation.

While the observed link between policy rates and inflation has been weak, the aggressive increase in policy rates may have had some adverse side effects on investment and growth.

Investment rate

Since March 2010, the RBI has been pursuing a policy of high repo rate with occasional minor cuts. During this period, the real rate of interest in India has been inordinately high in comparison with other major developing and developed countries. The Economic Survey of 2018-19 also notes that the cost of capital for Indian firms have been the highest in the world. The figures can touch upto 20 per cent in sectors like trucking, whereas they range between 5-10 per cent in countries like Japan and China.

During this period, the investment rate in India has been poor. One important indicator is funds raised for investment by the private corporate sector during 2011-2018. Soon after the massive increase in the repo rate in 2010-11, there was a massive decline in projects financed by various institutions; and during the period since 2011, the investment financed by these institutions has been at a low level with a small upturn in recent years. In Indian conditions, the repo rate is more powerful to depress private investment than to reduce the CPI.

If the government wants to increase the GDP growth rate to make India a $5-trillion economy (and provide decent jobs to the rapidly increasing labour force) over the medium term, the rate of investment will have to be increased, and for that purpose the real rate of interest has to be brought down to more normal levels. Under present provisions, the RBI has little incentive to take risks of lowering policy rates, which, while helping the investment rate, may lead to higher inflation. Similarly, in order to increase exports and promote import-saving, the exchange rate has to be made competitive, and this may require some depreciation.

Thus under present conditions, the RBI may constrain achievement of the goals of increased GDP and employment via higher investment and exports.

This is not to blame the RBI as presently constituted. In fact, its hands are tied legally to focus on inflation, with no obligation to facilitate any investment or growth target. Under the present conditions, moral suasion may not be enough to enable the RBI to help government is pursuit of its single-minded focus on growth and employment. To be fair to the monetary authorities, the Act itself may need modification, which only the Centre and Parliament can undertake.

For re-tuning India’s monetary policy framework, India may learn from the practices of Asian countries, such as China, Japan and Singapore in the early phases of their development, when they achieved rapid growth with stability without following any rigid mechanical rules about inflation targeting and by integrating monetary policy in an overall framework for macro-economic management. The time may have come to turn our gaze away from the West to the East. A new committee may be formed to prepare a report on the framework for integrated macro-policy management in the country to achieve its new goals on growth and employment and success of the Prime Minister’s people-oriented development schemes.

The writer is Formerly Distinguished Fellow, NITI Aayog

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