Anticipating a framework

RBI's new monetary policy target must be realistic

The Reserve Bank of India (RBI) is expected to put out its report on a new monetary policy framework, prepared by a committee headed by Deputy Governor Urjit Patel, in the next few days. Once the recommendations are accepted and implemented, this will be the first explicit articulation of a framework after the multi-indicator approach put in place during the governorship of Bimal Jalan 15 years ago. More recently, a number of people, including the Committee on Financial Sector Reforms, chaired by the present governor, have recommended a transition to a much more pointed approach, that is, inflation targeting. This essentially means that monetary policy actions will be predominantly, if not exclusively, driven by the inflation situation in the economy. RBI Governor Raghuram Rajan's initial brief to the committee was that it should take such recommendations into account in designing the framework. A second and persistent criticism of the RBI's approach has been its use of the wholesale price index (WPI) as the benchmark for inflation, when virtually all other central banks use some measure of consumer inflation, analogous to India's consumer price index (CPI). The introduction of a new, aggregated CPI three years ago could facilitate this transition.

Against this backdrop, expectations are that the committee will recommend both some form of explicit inflation targeting and the use of the CPI as the benchmark for policy action. But, assuming that this is the case, no one should expect a solution to the remarkably persistent inflation problem that the economy has been dealing with for the past few years. There will undoubtedly be a fair amount of trial and error and fine-tuning as the recommendations are implemented, along with reputation risks that will have to be carefully managed. Three considerations will be critical as the process unfolds.

First, what measure of inflation does monetary policy have an impact on, within a reasonable time frame? The role of food prices in the current inflationary situation is particularly significant in this context. With almost 50 per cent of the CPI basket accounted for by food and food prices being insensitive to monetary instruments, targeting the headline rate of inflation could become the policy equivalent of the dog chasing its own tail. A pragmatic target needs to be identified, an appropriate subset - a "core" - of the CPI basket, which would help preserve the RBI's credibility in terms of its commitment to its stated target. Second, if the new framework indicates, for the current inflation scenario, a stance that is considerably different from the current one, how will the transition be effected - rapidly or gradually? Either choice will have consequences for major macroeconomic indicators. Third, how is accountability for the target going to be achieved? In our system, it is entirely conceivable that the RBI's failure to meet its targets is the result of some other part of the system failing to do its job. In effect, all government agencies whose actions - or lack thereof - impinge on inflation need to be brought into the accountability framework. In short, a new, contemporary framework is welcome, but expectations from it need to be realistic.