RBI's Monetary Policy and Inflation targeting

In its first bi-monthly monetary policy review for FY 2021-22, the Monetary Policy Committee (MPC), voted unanimously to keep the policy rate (repo rate) unchanged at 4%. This is the fifth time in a row where MPC has decided to maintain the status quo.

• The six-member MPC, headed by the RBI governor, decides on the monetary policy based on the Flexible Inflation Targeting regime (FIT).
• The current Flexible Inflation Targeting regime (FIT) requires the RBI to keep Consumer Price Index (CPI) inflation maintained at the 4% ±2% level.
• The current FIT regime was adopted in 2016 based on the Urjit Patel report (2014) on inflation and the use of inflation targeting.
• Earlier in March, the government had decided to extend the current Flexible Inflation Targeting (FIT) regime for the next five years, starting April 1, 2021.

What is Monetary Policy?

• Monetary policy refers to the policy of the central bank (RBI) with regard to the use of monetary instruments under its control to achieve certain goals regarding the economy of the nation.
• The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy. This responsibility is explicitly mandated under the Reserve Bank of India Act, 1934.
• The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth.

• In 2016, the RBI Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting (FIT) framework (described in the background section).
• The framework aims at setting the policy (repo) rate based on an assessment of the current and evolving macroeconomic situation.
• Changes in the Repo rate transmit through the money market to the entire financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth.

• The amended RBI Act, 1934 also provides for an empowered six-member monetary policy committee (MPC) to be constituted by the Central Government.
• The six members include - three officials of the RBI and three external members nominated by the Government of India.
• The MPC determines the policy interest rate (i.e repo rate) required to achieve the inflation target (ie.4% ±2% ).
• Decisions are taken by the majority and the Governor has the casting vote in case there is a tie.

Several direct and indirect instruments are used for implementing monetary policy. Some of them are explained below.

• Liquidity Adjustment Facility (LAF): It is a tool used in monetary policy by the RBI, that allows banks to borrow money through repurchase agreements (repos) or for banks to make loans to the RBI through reverse repo agreements.
• Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight cash to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF). The current Repo rate is 4%.
• Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount commercial papers. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes.
• Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with the RBI as a percentage of its Net demand and time liabilities (NDTL) notified by RBI. THE current CRR is 3%
• Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to maintain in safe and liquid assets, such as unencumbered government securities, cash, and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.
• Open Market Operations (OMOs): These include both, outright purchase and sale of government securities, for injection and absorption of durable liquidity, respectively.

Recently a group of Economists made a presentation at the Observer Research Foundation, making a case against the FIT. In this light, we shall briefly examine the benefits and challenges of Inflation targeting.

• Benefits of Inflation Targeting
  • Enhances Transparency, Clarity, and Predictability of Monetary policy
  • Low and stable inflation is a prerequisite for sustainable growth for a country like India
  • An explicit target like this helps RBI in maintaining its autonomy and accountability
  • Empirical evidence from other countries has indicated that inflation targeting helps in achieving greater macro-economic stability.

• Challenges in Inflation targeting:
  • The sole focus on inflation undermines RBI other targets like growth and financial stability
  • There has been no empirical evidence of a clear linkage between Low inflation and financial stability.
  • In India, inflation is usually dominated by Supply-side bottlenecks (like poor agricultural production due to irregular monsoon. Under such a situation, monetary policy will have a limited role in easing the inflation
  • Inflation targeting is more suited for developed countries with good monetary policy transmission. Since the transmission is poor in India, it leaves inflation targeting policies virtually ineffective.

• Way forward
  • It is not clear whether any credible alternative to flexible inflation targeting currently exists that creates the right balance of rules and discretion in the hands of the central bank.
  • It is widely accepted that the earlier multiple-indicator approach could not maintain inflation at sustainable levels.
  • The RBI experience of 2009 shows how multiple objectives and indicators can lead to a costly policy error.
  • Therefore, it can be concluded that hurriedly abandoning the FIT regime would do more harm to India’s growth prospects and stability than aid it.

The RBI’s decision comes amid a surge in Covid-19 cases that has prompted many states to impose fresh curfew restrictions this week, triggering concerns over the economic recovery that is underway.

A wise monetary policy is the need of the hour so that India’s poorest, who are already hit by the pandemic, do not get further penalized and green shoots of economic recovery do not die out.