The right noises

Government must help RBI fix monetary policy framework

The report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework, chaired by Deputy Governor Urjit Patel, was published by the Reserve Bank of India (RBI) on Tuesday. The committee has drawn on several suggestions made by expert groups over the past few years; to that extent, its main proposals were widely anticipated. Some key recommendations are: the new consumer price index (CPI), combining the rural and urban sub-indices, should become the explicit benchmark for monetary policy; monetary policy should target inflation in a two per cent band around four per cent; the transition to this target should be phased, with a successive lowering to eight per cent next year and six per cent in 2015-16; liquidity management must be fully consistent with the monetary stance, to facilitate which a number of financial instruments must be introduced and the onus of decision making must shift from the current internal process to a formally constituted and accountable monetary policy committee, which will have three internal members out of five: the governor, the deputy governor, and the executive director in charge of monetary policy.

So far, so good. The broad model is largely in conformity with widely used global practices, including in several major emerging market economies, about which the report provides very useful information. The proposed composition of the monetary policy committee with the RBI governor as its chairman and majority representation from the central bank is significant as it departs from the recommendation of an earlier committee that had given the government greater leeway in nominating more members on the committee. There is also no reason to believe that any of these recommendations will in any way weaken the RBI's ability to control inflation and at least some of them will strengthen it over a period of time. The challenge, as always, comes from what the report expects other parts of the system to do. Two recommendations impinge directly on the fiscal condition. One asks the government to contain its deficit in line with the parameters laid down by the now-extinct Fiscal Responsibility and Budget Management Act, which lapsed in 2009. The current situation is far from those benchmarks and much repair work will have to be done, particularly with regard to the implementation of the goods and services tax. The second recommends the restructuring of the onerous statutory liquidity ratio (SLR), which has so far been an effective subsidisation of government borrowing by the banking system, in return for which the banks are exempt from mark-to-market requirements. The recommendation that the SLR be amended to conform with the liquidity buffer indicated by the Basel III framework will mean that the ratio will have to come down significantly and that it be subject to mark-to-market norms. This is an added inducement for the government to reduce its deficit, but it also means higher borrowing costs. Is the effectiveness of the framework going to be held hostage by the fisc?

The one issue that has been highlighted in the report but has not been articulated as a formal recommendation is food inflation. If it remains as high as it is now for a few years more, the target is likely to become increasingly elusive, particularly since rural wages are now effectively indexed to food prices. Ultimately, a policy framework is only as effective as the environment allows it to be. If indeed inflation management is high on the government's agenda, it needs to quickly articulate a strategy complementary to the one that has been proposed by the RBI.