Monetary policy path

Central bank may not cut rate in the near term

The four-year term of the three external members of the monetary policy committee (MPC) ends at a critical juncture, with inflation above the upper end of the target band. The minutes of the August meeting, released last week, indicated that the central bank might not be in a position to extend further support through rate cuts at a time when the Indian economy is expected to witness “its deepest contraction in history”. Inflation based on the consumer price index (CPI) inched up further in July to 6.93 per cent, compared to 6.23 per cent in the previous month. The expectation that the MPC would find it difficult to cut rates in the near term resulted in higher bond yields. RBI Deputy Governor Michael Patra, for instance, noted: “... if inflation persists above the upper tolerance band for one more quarter, monetary policy will be constrained by mandate to undertake remedial action, including an immediate and more than proportionate response to head off the build-up of inflation pressures and prevent it from getting generalised.”

Theoretically, even if the MPC decides to support economic activity through further rate cuts, it will not have the desired impact as the markets would quickly discount the possibility of a quick reversal owing to the prevailing inflation conditions. In this context, it is worth highlighting that some economists argue that the present CPI does not reflect the India’s actual consumption basket and may be overestimating inflation. As Ravindra Dholakia noted in his MPC intervention, the nationwide lockdown has significantly changed the consumption pattern, which cannot be reflected by the fixed base-weighted index. This would give an unrealistic measurement of inflation. Even without considering the impact of the lockdown, it is fair to argue that the consumption pattern of Indian households is changing rapidly and should be reflected in the official data. This would require gauging the consumption pattern more frequently. However, until such a mechanism is established by the government, the MPC will have to work with the given index, and it will be used to measure its performance.

As the MPC completes four years of operations and would soon have new external members, it is a good time to review how the committee functioned during this period. The adoption of the new inflation-targeting framework, which resulted in the constitution of the MPC, was one of the biggest reforms by the Narendra Modi government in its first term. The rate-setting committee was mostly able to keep inflation within the given target band except in recent months. The pandemic and its associated uncertainties have complicated setting monetary policy significantly. More broadly, the rate decisions were made after considering diverse views, which was reflected in the voting. A new paper by Pami Dua shows that of the 22 meetings held between October 2016 and March 2020, a consensus on the issue of direction of change or the status quo of the policy rate was achieved in 12 meetings. Of these 12 meetings, there were three instances when there was a consensus on the direction of change but difference in the magnitude. The voting pattern is comparable to other large economies. A committee approach for conducting monetary policy will be particularly useful in the current circumstances as it would help take better decisions. Price stability is critical for sustainable economic growth.