An RBI focus on targeting infl ation may be neither productive nor advisable.
The Reserve Bank of India’s (RBI) Expert Committee to Revise and Strengthen the Monetary Policy Framework, also
referred to as the Urjit Patel committee (after its chairman, a deputy governor of the RBI), has suggested making far-reaching changes to the monetary policy framework, the most important and controversial being the adoption of an inflation-targeting approach. The recommendations of the Urjit Patel committee on the monetary policy framework and those of the Nachiket Mor committee on financial inclusion bear a striking resemblance to some of the recommendations of the 2009 Committee on Financial Sector Reforms (constituted by the Planning Commission), which was chaired by the present RBI Governor Raghuram Rajan when he was not yet in the government or in the RBI. We may well be watching a root and branch overhaul of many aspects of the policy framework for the financial sector. Such a sweeping overhaul does need extensive discussion before it is carried out.
Other than the focus on inflation targeting, the Urjit Patel committee has been quite innovative. For example, to sterilise capital flows, it has suggested a phasing out of the existing instruments like the market stabilisation scheme (MSS) and cash management bills (CMBs) and has recommended the introduction of a remunerated standing deposit facility. While a technical analysis of the report can be carried out in the fullness of time, some broad-brush comments on inflation targeting are in order.
All these years, the RBI has refrained from pursuing a single objective. In keeping with the conditions in a developing, even if growing, economy the central bank has kept output, employment – and prices – in mind in its conduct of monetary policy. Yet what we now see is the Urjit Patel committee recommending the pursuit of a single objective – targeting inflation through the new combined consumer price index (CPI). This is in keeping with the 2009 Raghuram Rajan committee recommendation, “The RBI should formally have a single objective, to stay close to a low inflation number, or within a range, in the medium term, and move steadily to a single instrument, the short-term interest rate (repo and reverse repo) to achieve it.” The choice of CPI inflation as a nominal anchor will mark a major shift from the multiple indicator approach that has been followed by the RBI since 1998.
Inflation targeting, which was initiated in New Zealand in March 1990, soon became fashionable across the world. It was adopted in Canada, Australia, the United Kingdom, Sweden, Israel, South Africa, Latin America (Brazil, Chile, Mexico, Colombia, and Peru) and Asia (South Korea, Indonesia, Thailand and Turkey). Until recently the International Monetary Fund had been routinely advising central banks of developing economies (including India) to adopt inflation targeting. However, adoption of inflation targeting was, by no means, universal, and notable non-inflation targeting countries include the United States and China. This approach earned a bad name during the 2007-08 global financial crisis when countries with very low rates of inflation saw a major build-up of financial instability. Does the Urjit Patel committee then seek to align Indian monetary policy practices with the pre-crisis global paradigm of implementing monetary policy? Interestingly, the committee wants to take financial stability conditions explicitly under consideration and to that extent seems to have learnt the lessons from the global financial crisis. But clarity is still needed on the mechanism of inflation targeting with financial stability.
The Urjit Patel committee has not made a convincing argument for why there needs to be a drastic change in the policy preference of the central bank. After all, the previous RBI Governor D Subbarao had argued just a few years ago, in May 2011, that “Inflation targeting is neither feasible nor advisable in India”. Several reasons can be put forward for why this is so. Thus, if the nature of Indian inflation is structural in nature with the sources of inflationary pressure being food and fuel prices, then very little can be achieved by monetary policy actions operating within a framework of inflation targeting. On the contrary, a mindless pursuit of inflation control could have adverse effects on growth impetus. Besides, the emphasis at any point of time on growth vis-à-vis inflation is contextual and any presumed division of labour between the central bank and the central government in terms of control of inflation and generation of growth, respectively, may well turn out to be counterproductive in a developing country like India.
Finally, in the general perception inflation targeting as the objective of monetary policy is often associated with the clamour for central bank independence. Such calls do smack of fiscal fundamentalism. Admittedly, the adoption of inflation targeting (and the associated institutional changes that often follow, some of which have been recommended by the Patel committee) could make the central bank more powerful and keep the fiscal deficit of the government on a tight leash. This will make global financial market players, domestic private corporates as well as the Bretton Woods institutions happy. But between a democratically-elected government and a bureaucratic institutional edifice of a central bank, the ultimate responsibility for a system of economic management that reflects peoples’ choice must lie with the former.
It is from this standpoint that any possible adoption of inflation targeting needs to be seen with caution. Against the backdrop of the tensions of economic management in an election year, a major change in the monetary policy framework must be made after due deliberation and with caution.
