By Jignesh Trivedi
RBI on 12th September 2013 decided to constitute an Expert Committee to examine the current monetary policy framework and to recommend what needs to be done to revise and strengthen it with a view to making it transparent and predictable. The committee will be chaired by Dr. Urjit Patel, Deputy Governor, RBI and many other members.
The main objectives for the committee will be to review the objectives and conduct of monetary policy in a globalised and highly inter-connected environment, to recommend an appropriate nominal anchor for the conduct of monetary policy, to identify regulatory, fiscal and other impediments to monetary policy transmission, and recommend measures and institutional pre-conditions to improve transmission across financial market segments and to the broader economy etc.
To begin with there are multiple indicator available in order to frame the monetary policy of any country. These multiple indicators are many like growth, employment rate, inflation and exchange rate.
The committee appointed by RBI gave suggestion to solely focus on CPI and not on any other indicator. There are many reasons for choosing the CPI as nominal anchor for monetary policy. One of the reasons is that many countries in the world are now choosing this indicator as the base for their monetary policy but India and China. It is easy to track the CPI and even so called ‘AAM AADMI” can also relate the RBI’s monetary policy decision to increase or decrease the rate w.r.t CPI number. But the larger question is still how efficient is the inflation targeting for country like India?
There is always trade-off in keeping balance between growth prospects and inflation target. Supply side bottlenecks, fiscal profligacy, inefficient government policy and wider reach of intermediaries in agriculture cause inflation in India a more complex no. to interpret and handle. These factors that contribute the most to inflation are out of the reach of RBI governor. Generally good monsoon can ease the inflation pressure more than any REPO rate cut can. Moreover it is observed that onset of winter eases and summer heats up the inflation pressure.
Now with these recommendations from Urjit Patel committee Repo rate hike is the only tool that RBI can use to tame the inflation though it will hurt the growth prospects in India. In simple term:
Increase in repo rate will cause bank to borrow less from RBI and this increase in repo will pass on to customer by increasing interest rates. Now loans will be more costly and only businesses in dire need of money go for the loans from the bank. This will further affect the business growth. This will ultimately affect the employment rate and income level of the people. It will eventually lead to less demand. So now supplier will reduce the price to attract the more sales and inflationary pressure will be eased. So there is always trade-off between maintaining growth and controlling inflation.
Right now India is at the stage of low growth and high inflation. It means targeting CPI only and linking it with Repo rate may eventually worsen the growth prospects for India. No doubt inflation need to be controlled as it is eroding the purchasing power of people- especially lower middle class people and lower class people- and it is also affecting the demand side.
Food and fuel prices have weightage of 57% in the CPI. Therefore, for overall CPI to reach the targeted levels of 4% +/- 2%, this component has to come down, else it will require a dramatic fall in core (or non-food and fuel) inflation. For the CPI to hit target level of 6%, when food and fuel inflation hovers around 10%, core inflation has to go down to 0.7%. That will require a massive nine percentage point increase in the policy rate, a huge increase. And, of course, it will paralyze the economy. The concerns about high and persistent CPI inflation can be addressed by the supply-side measures along with the introduction of CPI-inflation linked financial instruments that would act as inflation hedges.
Recently RBI governor raise one complex issue: According to him Indian parliament should fix the inflation no. (i.e. 4% or 5% inflation) and task should be given to RBI to chase this. What more interesting is that Finance minister P. Chidambaram is also supporting the stand taken by RBI governor. As we have all witnessed minimal discussion of our parliamentarians on important issues like land acquisition bill, Telangana bill and many other important issues and the fact that Indian parliament is struck with low productivity and high absenteeism of our parliamentarians, how can this important issue be tackled by them. And there is also chance that political party in power can use populist measure to tackle this Inflation problem. Let’s wait for the decision by government on this issue.
But for now, RBI governor has a huge task of maintaining the growth numbers with adequate inflation to make Indian economy work efficiently. And this task do require the co-ordination from government as without effective fiscal policy whatever RBI do, inflation of 4-6% will only be a dream no. for the governor of RBI.