RBI Policy: All your questions, concerns about monetary policy panel addressed
Ideally, monetary policy should target producer prices which are what can be influenced by interest rates as there is leverage here.
The formal announcement of the setting up of the Monetary Policy Committee (MPC) comes a bit late as this had been agreed upon quite some time back. It was expected that the MPC would be in charge of the policy to be announced on the 9 August. However, it appears that the government would wait for the new Governor to take charge in RBI in September and then establish the MPC which will take be responsible for monetary policy action. But this is a matter of speculation.
The concept of a MPC is that when it comes to formulating the monetary policy for the country, the wisdom of experts from outside the RBI is also to be considered. Hence the Committee will have three members from RBI and three nominees of the Government who will be appointed by a Committee. This, to a large extent, should address the perceived conflict of view between the Ministry and RBI, where on several occasions it was felt that the latter was being recalcitrant with the conduct of policy and was hence against lowering interest rates. However, on second thoughts, this may not be true as the policy was always targeting inflation going by retail prices which is what is being said again. Can the vision be different then?
It does appear that there is nothing different from what was outlined earlier in the terms of reference of this Committee. There are also absolutely no changes in the content of agreement signed between the RBI and ministry of finance on the conduct of monetary policy, and the present announcement is only indicative of the urgency of the same.
It is now agreed to target CPI inflation. This is the starting point of debate because almost 90 percent of the index cannot be influenced by monetary policy. You do not borrow money to buy food and cannot do so for buying bus tickets or paying rent for your accommodation. To the extent we use credit cards and not pay on time, a decrease or increase in interest rates help. But the impact is marginal. Therefore, interest rates cannot affect inflation significantly.
But as has been argued before, maintaining real interest rates is an objective and the RBI has spoken of maintaining a real interest rate of 1.5-2 percent. Hence if inflation is say 5.5 percent and the repo rate is 6.25 percent, we are working with a real rate of 0.75 percent. This mean there is no serious case for cutting the repo rate going by this argument. Yet it has been felt that the RBI has been too hawkish.
Now look at the CPI target which has been placed at 4 percent with a band of 2 percent on either ends, meaning thereby that the inflation rate for all times should ideally be between 2 percent and 6 percent. Historically CPI inflation has been above 5 percent and it will be interesting to see how this number was pitched for as attaining 4 percent looks difficult given that we need to have positive inflation of 2 percent to provide incentive for manufacturing and food prices are bound to go up due to specific shocks as well as MSP (Minimum Support Prices) increases. But still this theoretically means that the repo rate cannot go below 5.5 percent going by the real rate argument.
Ideally, monetary policy should target producer prices which are what can be influenced by interest rates as there is leverage here. The WPI comes close to a producer index which could have been considered instead of CPI though globally CPI is used but in most countries. But households are leveraged which makes interest rate policy work.
The MPC will have to continue targeting CPI inflation and it will be interesting to see how differently it will react to the current inflation number. Logically it should be no different as we will still be looking at the same number. A different reaction has to be based on how inflationary expectations are interpreted by the Committee. This is so because whenever the RBI takes a call on inflation, it does take into consideration the future environment affecting the inflation rate. Also it will have to be seen as to how the repo rate will be calibrated with CPI inflation. If CPI inflation comes down from 5.5 percent presently to say 5 percent, then will the repo rate be lowered? And in an analogous situation if the rate moves from 5 percent to 5.5 percent, will the repose be increased. This will be the prerogative of the MPC.
An interesting clause inserted in these guidelines is that if the inflation number is outside this band for more than three quarters, then the MPC will be held responsible for the same. Two issues come up. First when they say that the MPC will be responsible will it mean that punitive action will be taken or will the committee be reconstituted? This has not been spelt out and is hence open-ended. The second is that inflation can go up with a monsoon failure or supply shocks in say potatoes, tomatoes or onions, where the MPC has no control. What will be the view taken by the government on the MPC?
The creation of the MPC and the role assigned to it to form monetary policy will be a new way of doing things on our country. There is a technical committee which already exists today which deliberates such action but the RBI Governor has the final say. Now, the RBI governor will have the overruling power only in case of a tie break. But if four of the six members think otherwise their opinion will prevail. To this extent, the power do the RBI will be modified and the overwhelming presence of the Governor’s view will get diluted.
The new regime will be different from the existing one and the interpretation of inflation will be important as it will guide future action. Will it finally be the same? This cannot be ruled out and only time will tell. One may recollect that when Dr Subbarao had moved out of RBI and Dr Rajan had taken over it was expected by India Inc. that he would start easing rates even as CPI inflation was high. But this did not happen and there was continuity.
The next RBI policy meeting too could be benign. The progress of the monsoon and a clearer picture on oil will be the clues for both inflation and policy.
The decision of the MPC is consistent with an accommodative stance of monetary policy in consonance with the objective of achieving consumer price index (CPI) inflation at 5 percent by Q4 of 2016-17 and the medium-term target of 4 percent within a band of +/- 2 percent, while supporting growth
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