Government and RBI should jointly agree on an inflation target

RBI should be given full autonomy to pursue the target rate

RBI Watch                                                                                    Monetary Policy 2014-15

A little over a week ago the Hindu on its front page carried a news item titled “Centre to set inflation targets for RBI”.  The report indicated that the Indian government felt that RBI could not be the one to decide what the inflation target for the country should be, but instead the government was in a better position to do so.

The background to this news item has its origin in Reserve Bank of India Governor Rajan’s appointment late last year of a committee to examine the goals and process of monetary policy formulation. The Urjit Patel Committee gave its recommendations early this year. It recommended, among other things, that RBI should adopt inflation targeting, target an inflation of 4% + or – 2%, and chose Consumer Price Inflation (CPI) as the benchmark for measuring inflation.

What is inflation targeting? Inflation targeting happens when the central bank makes public a specific target for inflation and then attempts to steer inflation to that target using monetary policy tools, such as the interest rate. What this means in practice is that achieving the inflation target becomes the predominant objective, perhaps even the sole objective, of monetary policy. It also means that the central bank becomes clearly accountable to government and the public in case it does not reach the inflation target.

Should RBI be given the responsibility to decide the appropriate rate of inflation? The Urjit Patel Committee made it clear that RBI should set the target rate, indicated the target rate as indicated above, and RBI has since been pursuing its interim targets– 8% by January 2015 and 6% by January 2016. Note, Rajan recently stated that RBI has not adopted inflation targeting.

Inflation is an economic and social phenomenon, and it is fair to say today that the Indian government, duly elected by the people, has a better pulse of what the inflation rate for India should be. The government controls huge swathes of the economy, both directly and indirectly. It has also in its power measures to reduce the frictions in the economy and thereby contribute significantly to controlling inflation. I therefore suggest that the target inflation rate for India should be set jointly by government and RBI. It should be reviewed every two years. RBI should be given full autonomy by government to pursue the inflation target, once set.

Second, should the RBI go in for inflation targeting?

If RBI adopts inflation targeting, as it is currently practiced, then its predominant objective becomes achieving the target rate of inflation. RBI has far less control over the underlying dynamics of inflation than in a developed country. Firstly, much of the economic transactions in the economy run in the informal sector – financed primarily outside the banking system. Even in the formal economy, RBI’s changes in its key interest rate – the repo rate – have a somewhat weak link with the cost of funds of banks, and its signalling role to markets is still evolving, given that much of corporate borrowing is through banks. Two, a large number of markets across industries lack transparency, some are dominated by black money, and some others are oligopolistic or monopolistic. Three, in many sectors wages, interest rates, and prices are not set by market forces. Four, government owned enterprises and departments still dominate many sectors of the economy.Finally, by the RBI’s own admission, food and fuel account for more than 57 per cent of the inflation rate (consumer price inflation) on which the direct influence of monetary policy is limited (page 20, Urjit Patel Committee Report). RBI does, however, have influence on the secondary effects of food and fuel inflation.

Under these circumstances, the bias of RBI to my mind will be to have a tighter monetary policy than necessary.  (I do not imply that is the case today. I am referring to monetary policy as it evolves on average over time. ) How else will RBI reach its target, for which it is publicly accountable?

I do believe in an independent central bank, which unrelentingly deals with a strong hand on inflation. The primary objective of monetary policy should be growth –actually employment - with price stability, especially so in a developing country like India. This should be backed by a formal target on inflation for the RBI. (Note the Federal Reserve of the U.S. and the European Central Bank, both very successful central banks in dealing with inflation, have an implicit inflation target.)

But this inflation target needs to be government’s target also. The Indian government has been obsessed with the growth mantra. Given that the government controls huge swathes of the economy, and a large percentage of the population lives below or just above the poverty line, the government must commit itself to an inflation target - an inflation mantra. Inflation is as much an evil as growth is a blessing. And in the long run, there is no trade-off between inflation and growth. RBI’s study shows that when inflation rises above 6%, it is harmful to the growth of the economy (page 18 Urjit Patel Committee).

What should be the process for deciding the course of monetary policy?

The Urjit Patel Committee suggested moving the responsibility from the Governor of the RBI to a Monetary Policy Committee (MPC). This makes sense.

The Committee suggested that the MPC should consist of the Governor, a Deputy Governor, an Executive Director of RBI, and two external members picked by the RBI. My view is that to start with we need a small MPC of four members, consisting equally of internal and external members. I suggest two external members, both persons of independent standing with experience in fields such as of banking, finance, industry (agriculture or manufacturing) and sociology. Government should pick these members in consultation with the Governor.  The two internal members will be the Governor and a Deputy Governor in charge of monetary policy at the RBI. In the event of a tie, the Governor should cast one additional vote.