RBI should anchor monetary policy on managing inflation: Panel

22 January 2014

The Reserve Bank of India (RBI) should anchor its monetary policy on managing inflation, especially since inflation expectations have remained sharply high, unhinged from the low inflation experience of 2000-07 as also from the global inflation record, an RBI panel has recommended, a shift that would bring its practices in line with most other central banks.

In recent years, inflation in India has been amongst the highest within the G-20. Household inflation expectations have risen sharply and have remained at elevated levels, the panel pointed out.

The panel, set up by RBI governor Raghuram Rajan, also recommended using consumer prices as the primary measure of price changes and setting an eventual inflation target of +/- 2 per cent.

The consequences of persisting high levels of inflation can be far reaching. First, real interest rates have remained negative for savers during most of the post-global crisis period, leading to a decline in domestic financial saving.

Second, since India's inflation has persisted at a level higher than that of trading partners, external competitiveness is getting eroded. If the nominal exchange rate adjusts to offset the inflation differential it can set off a depreciation inflation spiral, thereby undermining macroeconomic stability.

Third, as the recent experience demonstrated, the large demand for gold as a hedge against inflation exacerbated the decline in financial savings and contributed to a widening of the current account deficit (CAD), rendering the economy vulnerable to external shocks. Fourth, the consequent weakening of the exchange rate has imposed balance sheet risks on borrowers in foreign currency with the potential for financial instability.

Fifth, persistently high inflation adversely impacts the economy's allocative efficiency and impedes growth.

Sixth, high and persistent inflation contributes to a worsening of income distribution as the poor use disproportionately higher cash-in-hand as part of their savings.

Given the current high level of consumer price inflation, which is close to 10 per cent, the change in focus could mean interest rates stay higher for longer.

RBI would use consumer price index inflation, which now stands at 9.87 per cent, as the benchmark for targeting inflation.

If adopted, the new monetary policy would aim at a phased reduction of consumer inflation to below 2 per cent levels over the next few years.

It would aim to pare CPI inflation to 8 per cent over the next 12 months and 6 per cent in the next 24 months. Its eventual target level would be 4 per cent, plus or minus 2 per cent.

RBI has all the while been relying on the wholesale price index, which eased to a five-month low of 6.16 per cent in December, and have not set a specific target, except suggesting a comfort zone of WPI inflation of around 5 per cent.

The central bank, which has been anchoring its inflation policy on the wholesale price index, had been widely expected to keep its policy repo rate unchanged at 7.75 per cent at its next policy review due on 28 January.

In its 130-page report, the panel has recommended that managing inflation take precedence over the other current main objectives of economic growth and financial stability.

Besides, the panel has recommended that monetary policy decisions be made by a committee, which would consist of five members, including the governor, a deputy governor, the executive director in charge of monetary policy and two external members appointed by the RBI.

Currently, the RBI governor is the sole decision maker on monetary policy, though he is advised by his four deputy governors and a technical advisory committee.

The Monetary Policy Committee, headed by the RBI governor, will be accountable for failure to establish and achieve the nominal anchor.

Failure is defined as the inability to achieve the inflation target of 4 per cent (+/- 2 per cent) for three successive quarters. Such failure will require the MPC to issue a public statement, signed by each member, stating the reason(s) for failure, remedial actions proposed and the likely period of time over which inflation will return to the centre of the inflation target zone.

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