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Posted by: Deepa Vasudevan on Sat, Jan 25th, 2014

A New Year. A New Monetary Policy Framework?

The Expert Committee to Revise and Strengthen the Monetary Policy Framework has stirred up a great deal of discussion on the future direction of monetary policy in India[1]. The Report of this Committee, chaired by Shri Urjit Patel, has recommended major changes to the conduct and objectives of monetary policy. The timing of its release, about two weeks before the third quarter review of policy on January 28, 2014, is apt, as it allows the market just enough time to assess, debate, and absorb the suggested reforms, while giving RBI an opportunity to gauge market reactions.


Three key ideas are addressed in the report.


First, the committee makes it clear that CPI, and not WPI, should be the inflation metric tracked by policy makers. It has clarified that headline inflation, which includes volatile elements such as food and fuel, is more relevant than core inflation even though prices of food and fuel cannot be impacted by monetary policy tools. One of the startling findings of the report is that a 1% shock to food inflation immediately affects one-year ahead inflationary expectations by 50 basis points, and the impact persists for 8 quarters. The takeaway: food inflation matters to households, who assume it will persist and pass on to headline inflation with a lag. So if policy makers want to anchor inflation expectations, it is critical to focus on CPI (which gives a 57% weight to food and fuel). If the report is accepted, WPI, despite its past popularity, has to be sidelined in favour of CPI. 


Second, it envisages the setting up of an independent Monetary Policy Committee within the RBI, with the right to set inflation targets, as well as accountability for any failure to achieve it. This is to ensure that there is no political pressure on the central bank to deviate from its inflation target.


But the most radical recommendation of the Committee is that RBI should explicitly announce and consciously adhere to a nominal inflation target of 4%, allowing for a variation of 2% in either direction. Since CPI inflation is presently in the region of 10%, this target is to be achieved gradually. The RBI is expected to consider other objectives such as growth, financial stability or managing exchange rate volatility only after inflation targets are met.  In effect, RBI is required to move from a multiple objective system to an inflation targeting one.


The impact of this was immediate: bonds fell steeply on the fear that sharp interest rate increases would be necessary if the Patel committee’s targets were adopted. A moderate recovery happened only after the Economics Affairs Secretary announced that it was premature to consider inflation targeting, particularly in view of the many data imperfections in the new CPI index.  If the RBI was testing the waters before shifting to a different monetary regime, then the response was clearly delivered: weak growth and somewhat dampened inflation had led markets to expect a status quo in rates, if not a rate cut; a rate hike was quite unacceptable!


What if the recommendations were actually implemented? Pic 1 shows that inflation based on CPI index is more than 5% away from the target rate. To reach this target the RBI would need to carry out sharp rate hikes over a prolonged period of time. In the very short term, rate tightening would squeeze liquidity, reduce debt prices, and may even set up the kind of panic that was observed in August 2013 when RBI tightened to protect the rupee. Growth would be harmed too, and as a consequence equity markets would lose value. 


Pic 1 Divergence between CPI and WPI


Pic 1 Divergence between CPI and WPI


Source: RBI


Over a longer period, the response of the market would depend entirely on the support provided by government policy.  If the new government that takes over in 2014 implements policies that support growth, reduce subsidies, and control government spending, a growth revival may take place. As the committee has pointed out, it is impossible to achieve inflation targets without supporting fiscal policy. Government policy often runs counter to monetary stance. For instance, in the middle of a rate tightening cycle, RBI often conducts open market operations, supposedly to  ease liquidity, but more likely to ensure lower yields for government borrowings. If the fiscal deficit was brought under control (the committee recommends a deficit upto 3% of GDP), instruments such as high SLR, moral suation of banks, or high interest small savings, all of which prop up government debt but distort the yield curve, would not be needed.


Finally, there are no short cuts to prosperity. Setting up a more transparent, rules-based monetary policy framework may help to control inflationary expectations but that may come at the cost of other macro-variables. To balance the economy, both monetary and fiscal policy have to work together.

[1] The Report is available at  the RBI website at

Tapan Mukherjee on Mon, Jan 27th, 2014 11:10:16 am

Apart from inflation rate, WPI, bank rate global money market linkages also play a part in money market demands. Indian money flowing out to foreign banks come back more often as FIIs and FDIs which creates undue pressure on economy for repayment in dollars. Short term dollar payouts is gradually forming substantive impact on rupee availability.

Manojkumar Sinha on Sun, Jan 26th, 2014 5:54:24 pm

in this situation we need wait and watch the political changes and then the decision taken thereafter

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