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The Bane of Monetary Policy

The RBI’s stubborn stance on inflation has its roots in the government’s own economic policies.

The government’s public disapproval of the Reserve Bank of India’s (RBI) refusal to reduce the rate of interest once again at the second bimonthly monetary policy review on 7 June 2017 that would have facilitated a reduction in bank lending rates and help boost growth, is rather perplexing. The chief economic advisor ought to have realised that the RBI’s stubbornness, a display of its independence, in pursuing a narrow, single-minded policy perspective of inflation targeting, contrary to the government’s explicit wishes, is directly inspired by the government’s own policy of stabilisation rooted in the theology advanced by the International Monetary Fund (IMF) and the World Bank. It is a different matter that the RBI did not exhibit such independence when the government interfered with its autonomy during demonetisation and in a few other administrative matters.

That apart, the central bank’s own image has been one of overtly promoting the IMF’s stabilisation programmes during the past two decades or so. More specifically, a paper which is the outcome of a “technical collaboration” between the RBI and the IMF, provides an outline of the analytical framework for such an inflation targeting policy. It seeks to concretise what is called flexible inflation targeting (FIT) recommended earlier by an expert committee headed by the current RBI Governor, Urjit Patel. The committee had exhibited a single-minded devotion to controlling inflation through a unique interest rate channel. It had accordingly recommended a nominal inflation rate of 4% of which operated around a ± 2% band based on the consumer price index (CPI). This has been imposed statutorily by the government on the monetary system after it signed the Monetary Policy Framework Agreement (MPFA) with the RBI in February 2015.

The primary objective of monetary policy was thus ordained as one of maintaining price stability. For this, RBI has to establish an operating target and an operating procedure. With the amendment of the RBI Act, the central government, in consultation with the RBI, notified the inflation target mentioned which is applicable for the next five years until March 2021. If it fails, the RBI shall explain the failure and propose remedial measures, and state the time required to bring inflation to the target level; as though monetary policy alone was capable of inflation control.

Thus, there is this sword of Damocles hanging over the RBI’s head to ensure that the inflation target is met. It is a different question that this imposition is the result of the RBI’s own initiative, based as it is on a blinkered view of the macroeconomy. The propagation of FIT has also been done with a selective and biased view of other country experiences, some of which have no doubt been ­successful in moderating commodity inflation, but admittedly at the cost of output, employment growth, and social welfare. The propagation is further buttressed by the theoretical construct of “rational expectations” (RE) which stands largely discredited in recent economic literature. As articles in this journal have brought out, the RE hypothesis fails to recognise the limits on individuals’ rationality imposed by cognitive liabilities.

India adopted the FIT framework despite opposition to it from even former RBI governors. Those opposing it rightly contended that focusing only on inflation while ignoring the wider developmental issues is improper and supply-side influences, which are beyond the control of monetary policy, are more dominant in Indian inflation. The monetary transmission mechanism here faces untold hurdles, including the complex nature of economic structures that prevent the spread of monetary signals.

Just to cite the importance of supply-side issues, studies show that of the 117% increase in the CPI during the decade between March 2007 and March 2017, 53% has been contributed by the food index. In absolute terms, the food index has increased by 131%, while the non-food index has risen by 104% during the decade. Interestingly, even under the wholesale price index (WPI), the price index for food items has risen by 108% while prices of all other non-food items have risen by less than half. No doubt, food items in the commodities basket have considerably diversified with a shift in favour of millets as well as fruits and vegetables. Their prices do translate into higher prices in non-food items and also into the general inflationary spiral. But that is at a second stage when there can be varied forces operating in the economic environment; it provides no justification for squeezing the growth process by a restrictive anti-inflationary policy.

Reducing the inherently complex issues involved in monetary policy strategy to a single, simplistic nominal anchor, which is what has been done in the FIT framework, appears textbookish and lacks depth. Interestingly, studies done in the RBI (Bulletin, March 2010) have shown how the multiple indicator approach was successful on all fronts: in actual growth of gross domestic product, in inflation control, and in reducing volatility of the WPI. The only exception was the increased volatility in the CPI due to food prices, thus underlying the importance of supply management.

Considering the complexity of India’s economic structure, and its multiple social, fiscal and monetary needs, the earlier multiple indicators approach adopted by the RBI that was informed by varied financial and real sector variables has a strong case for deployment in monetary policy.

Updated On : 16th Jun, 2017

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