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Business News/ Opinion / Online Views/  Making sense of the new monetary policy framework
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Making sense of the new monetary policy framework

The new monetary policy framework is welcome, even though we have doubts about its institutional details

The Reserve Bank of India (RBI) will now formally target a particular level of consumer price inflation. Photo: Pradeep Gaur/Mint (Pradeep Gaur/Mint )Premium
The Reserve Bank of India (RBI) will now formally target a particular level of consumer price inflation. Photo: Pradeep Gaur/Mint
(Pradeep Gaur/Mint )

Indian monetary policy has entered a new era.

The Reserve Bank of India (RBI) will now formally target a particular level of consumer price inflation. The traditional practice of having multiple objectives has been given a burial. This radical change follows many years of heated debate about what the central bank should be doing; and whether high inflation in India is fundamentally its fault rather than other factors such as commodity price shocks or massive fiscal expansion.

Nobody can doubt that inflation control should be the primary goal of any central bank. The more complicated question is whether it should be the only goal. This newspaper has never agreed with the view that a central bank should target inflation alone, especially in an emerging market economy such as India. Exchange rates and financial stability also matter because of pro-cyclical capital flows. The logical corollary of a single target such as inflation means that there should be a single policy instrument, going by the famous Tinbergen assignment rule that is the bedrock of policy thinking. That single policy instrument is usually the short-term interest rate, or the repo rate in the Indian context.

The years after the global financial crisis of 2008 saw the earlier consensus crumble. Many countries have gone beyond interest rates, by trying to stimulate economic activity by increasing the monetary base through quantitative easing. The Swiss even tried to manage their currency. The US Fed under Janet Yellen has reactivated the second part of its formal dual mandate, by suggesting it would not raise interest rates despite stable inflation, unless labour market conditions improve.

The Indian central bank had swung to the other extreme by embracing an eclecticism that was close to confusion. In that sense, the new monetary policy framework is a step in the right direction. It will lend greater clarity to Indian monetary policy. That has quite naturally been welcomed by participants in the financial markets.

However, the actual agreement between the finance ministry and RBI raises several interesting questions.

First, it says that “… the objective of monetary policy is to primarily maintain price stability while keeping in mind the objective of growth". This is a dual mandate rather than pure inflation targeting. It is quite possible that the more radical shift towards proper inflation targeting cannot take place without an overhaul of the Reserve Bank of India Act, which asks it to maintain monetary stability as well as meet the credit needs of the economy.

Second, the statement published on Monday says that there has been an agreement between the finance minister and the RBI. This is ambiguous. Who has actually decided the target? The government or the central bank? This is an important issue. Most countries with similar monetary policy frameworks allow the government to provide the central bank with an explicit inflation target. There are risks to such an arrangement in the Indian context, because of the inflation bias in government policy. It is quite possible that the government will give an aggressive inflation target but then set the RBI up for failure through unwarranted fiscal expansion, say in an election year. Economists will recognize incentive compatibility issues in such an arrangement. The result will be a holy blame game. Hence, it is our view that the new monetary policy framework could be at risk unless it is matched by a new fiscal policy framework with strong limits on government deficits.

Third, it is puzzling why the decision on interest rates has been left to the governor or deputy governor when there is an overwhelming consensus that rates should be set by an empowered monetary policy committee. The only issue of debate was whether the finance ministry should have any representation on such a monetary policy committee. The presence of government officials on the policy committee will go against the very idea of a central bank that has operational independence. It is still not clear why the monetary policy committee idea has been kept in abeyance.

The new monetary policy framework is welcome, even though we have doubts about some of its institutional details. It should be seen as part of an overdue change in the Indian policy arena, with a shift away from discretion to rules.

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Published: 03 Mar 2015, 09:57 AM IST
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