Towards a rules-based policy

AReserve Bank-appointed committee headed by Deputy Governor Urgit Patel was asked to revise

and strengthen the monetary policy framework in India. In its core recommendations it wants monetary policy to formally move towards using headline CPI (Consumer Price Index) as its nominal anchor. Communicating the nominal anchor without any ambiguity will be a key task. The objective is to ensure a monetary policy regime shift away from the current approach, which has multiple objectives, to one that is centred on the target CPI. However, taking into account the current macroeconomic scenario, the committee has conceded the need for flexibility in inflation-targeting to enable the central bank to deal with other objectives in the short run. The ultimate goal is to contain CPI inflation within a target band of 4 per cent plus or minus 2 per cent. A smooth two-year transition is envisaged. From the current 10 per cent levels, CPI inflation is to be brought down to 8 per cent in 12 months and to 6 per cent in 24 months. Monetary policy will henceforth be conducted by a new Monetary Policy Committee which will have the Governor as its head and three senior officers of the RBI as its members. In addition, two outside experts will be nominated. All members will vote on the policy at meetings every two months. The MPC will be accountable for any failure to achieve the inflation target.

The committee has suggested crucial changes in the operating framework and instruments in the conduct of monetary policy. Its report has generally been received well by banks and financial markets. It enables policy formulation in a phased and transparent manner using a real policy rate as reference. Over the medium term, the recommendations will help develop a term money market, reduce fluctuations in market liquidity and remove distortions in interest rates. Its unrelenting focus on inflation is justified on several counts — India has the highest rate of inflation among G-20 countries. Inflation expectations are deeply entrenched and inflation at current levels is inimical to medium-term growth and macroeconomic stability. Understandably, Finance Ministry officials are not happy with proposals that would strengthen the central bank’s case for complete autonomy in matters of monetary policy. The fact that monetary policy has very little influence over high food inflation that has pushed up the CPI, could limit the efficacy of the new approach. All these do not detract from the fact that a shift to a rules-based policy framework recommended will replace the purely discretionary approach the RBI has followed so far, and is therefore to be welcomed.