RBI’s monetary policy has been circumscribed by CPI inflation targeting…

Worldwide central banks are getting criticised for their narrow inflation targeting mandates. Latest is this piece which has asked BoE to include growth in its target. NZ has already widened its mandate by including employment.

The how can India which has just recently moved to inflation targeting be left behind?

EPW’s recent editpiece argues to revisit the mandate. They say RBI recent rate hike is a Pavlovian response (:-)):

The Reserve Bank of India (RBI) has indulged in one more Pavlovian response to the self-propagated inflationary expectations by increasing the policy (repo) rate for the second time in succession—first from 6% to 6.25% and further to 6.50%—along with similar quarter percentage point increases in the reverse repo rate, the marginal standing facility rate, and the bank rate. The objective is to push up the cost of liquid funds supplied by the RBI to the banks and consequently make bank loans more expensive for the borrowers; potentially to contain retail inflation within the mandated range.

It is indeed disconcerting that in the management of the national economy the two potent instruments of public policies—fiscal and monetary—have been pigeonholed into a narrow groove of the liberal economic framework, barring them from serving the wider objectives of higher growth, more employment opportunities, and diminishing social inequalities. The path of fiscal consolidation has led to inadequate allocation of public funds for social sectors, where India’s progress stands behind many peer countries. The incidence of such a phenomenon has further widened inequalities in the system.

In the case of the monetary policy, the RBI’s sole responsi­bility has been narrowed to a legislative mandate of inflation targeting within a range of 4%, +/–2% in the medium term, subject to a single interest rate policy vis-à-vis the liquidity adjustment for banks. Almost all retired RBI governors have objected to such circumscription of monetary policy, broadly on the grounds that exclusive attention to inflation is defocusing the central bank of its larger developmental objectives. Much of the inflationary processes in India are driven by supply-side issues over which the RBI has little control. Thus, the monetary policy transmission mechanism remains a weak spot. Various independent studies have questioned the RBI’s claim that movements in CPI inflation rates have been achieved by its repo rate changes.

Also, there are multiple measures of inflation—consumer price index (CPI), wholesale price index, and the gross domestic product (GDP) deflators—with each having different relevance for different players, namely, consumers and producers. A classic example is the successful dairy movement in Gujarat, which had proved that price increases in a developing economy serve as incentives for producers to increase production. Considering the relative price behaviour of various commodities and services, the 4% CPI target may be unduly low. Within inflation, there are subsets such as headline and core inflation. But, as the RBI governor admitted at the latest press conference, “The legislated target is on CPI headline and our policy is oriented to keep that at 4%.”

It is high time for both the RBI and the government to make a choice between legislative mandates of inflation rate targeting and a holistic approach for development management. The RBI should aim at promoting financial savings in the economy, which is a crying need; ensure a positive real rate of return to depositors on their bank deposits, which still remains a major and easy instrument of making savings for the vast masses; and customise fiscal incentives for small savers who, despite predominating the saving community, are usually bypassed by fiscal interventions. While it is not the intention to revert to the erstwhile rigorous interest rate control regime, one single prescription, namely bank deposits with a one-year maturity should get a minimum of +2% real rate of return on the previous year’s CPI inflation rate. The other prevalent savings rates, including the savings deposit rate, the postal rates, etc, will get adjusted over time. The additional cost of funds so imposed on the banks will be taken care of in the marginal cost of funds based lending rate (MCLR) which has been prescribed for banks to follow.

On the matters relating to the deployment of bank credit for development purposes, one gets a distinct impression that the authorities are overwhelmed by the twin balance sheet problems of corporates and banks due to non-performing assets (NPAs). On the other hand, there is an overwhelming dominance of the informal sectors in the Indian economic structure which are neglected by the banking system. Since the Indian banking system has not tapped the millions of unincorporated enterprises operating in different sectors of the economy, India’s private bank credit to GDP ratio is as low as 52% in comparison to the 110% or more in many comparable economies. Substantial thinking should go into the organisational and instrumental needs of banks for tapping these potentially large numbers for productive credit dispensation. Also, the industrialisation process has suffered due to the closure of large development finance institutions, and the new proposal made by the RBI almost a year and a half ago has not taken off. But, no attempt has been made to find out why. A plausible ideological weakness of this proposal is its exclusive emphasis on the private sector–led non-banking finance companies. These can never mobilise the required resources for rendering long-term finance for industry unless there is public sector support.

Considering, thus, the vast sets of developmental issues awaiting the attention of the RBI and the government at this stage of development, it is time that a high-powered commission is appointed to undertake detailed probing of the issues involved and come out with appropriate recommendations.

These arguements are barely new. Infact as it was felt that RBI has been unable to do so many functions leading to ignorance of inflation. leading to regime of inflation targeting. The whole idea that RBI should play a role in development of the country is as old as the institution itself.

But then we are living in such times that old arguments keep coming back given the dissatisfaction with the overall state of economy. Just that they have come a bit too soon in case of RBI…


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