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.
