Old policy, new bottle: RBI-govt pact on targeting inflation won't change much

The government and the Reserve Bank of India (RBI) are busy discussing a new monetary policy framework under which the government would set the desired inflation target for the central bank from the next fiscal year, while the central bank will then try and achieve that target with the tools at its command.

Going by the indications at this stage, a committee comprising, RBI, government officials and outside experts will advise on the desired policy outcome and the inflation target.

The stated idea behind this move, first mentioned in the 2014-15 Union budget by Finance Minister Arun Jaitley and in line with the recommendations of an RBI expert panel, is to make inflation fighting easier for the central bank with a government-endorsed target, thus aligning the thought process of the central bank and the political leadership on policy priorities.

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According to a Bloomberg report, the government has, in principle, in agreement on two issues. One, the consumer price index-based inflation (CPI) number will be the primary price indicator to devise monetary policy, and two, give the RBI governor the veto power to overrule the committee’s views.

The critical point to be noted here is that the whole understanding on inflation targeting will be materialised through the signing of an agreement between the apex bank and the government, and not through a change in the legislation that governs the mandate and operations of the central bank.

This could also mean that the agreement between the government and the monetary authority will subsist only during the lifetime of a government. It will not be codified into the law - as suggested by the Financial Sector Legislative Reforms Commission (FLSRC) headed by Justice BN Srikrishna_.(Read the FSLRC reports here)._

A Prasanna, chief economist at ICICI Securities primary dealership, is quoted in the Bloomberg report as saying, “at any point, a future government can change it,” giving uncertainty on inflation targeting in India. Given that the central bank’s inflation fight is meant for a longer period, changing governments can certainly create uncertainty on such a mutually agreed mandate.

Let’s be clear on a few things:

Even now, the RBI’s primary focus is fighting retail price inflation. That has been so since the regime of former Governor D Subbarao and that stance has continued strengthened further under current Governor Raghuram Rajan.

The central bank, in multiple occasions and in as many words, has reiterated its stance of focusing on the inflation fight even at the cost of sacrificing growth in the short-term.

Post the proposals of the Urjit Patel panel, the RBI has formally accepted the 8 percent retail inflation target by next January and 6 percent a year later, and has said in concrete words that it won’t cut rates unless inflation declines on a sustainable basis.

The key change under the proposed government-RBI agreement would be the creation of a monetary policy committee (MPC), though there is uncertainty about its composition. Even now, there is a technical advisory committee on monetary policy which makes suggestions to the RBI Governor. It has been doing so since February, 2011, which has, besides the RBI governor and deputy governors, seven external members, which advise the governor on the policy. However, monetary policy remains the domain of the Government. An MPC, even if it can be over-ruled by the Governor, would alter the structure.

Currently, the RBI Governor consults with the finance ministry prior to the announcement of the monetary policy. By the Act that governs the RBI’s operations, the central bank is theoretically not an independent, autonomous body and is answerable to the government.

So, what will change with the new, proposed framework when it comes to the central bank’s inflation fight? Not much, but the chemistry between central bank and government would improve since the goal would be agreed in advance. Central bank officials can then work without fear on how the political leadership in Delhi would respond to their policy decisions.

The fact is that, regardless of any change in the policy framework, the challenges pertaining to the central bank’s inflation fight in India remain the same. Most economists agree that the real reasons for the current high inflation relate more to supply constraints than demand pressures. Solely targeting inflation through demand side restraints and interest rates has failed in some of the global economies.

In May 2011, former RBI Governor Subbarao said that inflation targeting cannot be a formal policy for India. “Inflation targeting is neither feasible nor advisable in India, and for several reasons,” Subbarao said. Monetary policy has limited powers to contain a supply side-driven inflation and the steps for this should come from the government through a combination of measures to improve production of food and vegetables.

Food inflation has played a key role in propelling inflation in recent years and the level hardened to 9.42 percent in August from 9.36 percent a month ago.

The RBI, under Rajan, has given much thrust to the 6 percent inflation target by January 2016 and has shaped its monetary policy objective to achieve that level.

Arguably, the RBI has succeeded so far in that battle. If the proposed body suggests a new course, will the central bank change course midway?

To be sure, any major change in the desired inflation targets is unlikely. At least three senior economists Firstbiz spoke to said the desired retail inflation level that will be arrived by the new council cannot be drastically different from the current thought process in the RBI.

That’s because the available macro variables/indicators used to estimate the targets remain the same regardless of whoever look at it.

If the government is sincere about giving more firepower to the central bank on its inflation fight path, the proposed changes in the monetary policy framework should be executed through appropriate changes in legislation and not just through an agreement with the government in power.