Monetary Policy in India

Brief background of Indian Monetary Policy

The monetary policy framework in India and the associated operating procedure have evolved over
time. The structural reforms and financial liberalization of the 1990s marked a paradigm shift.
Swings in capital flows and rising volatility of the exchange rate made it difficult to target
monetary aggregates. Interest rates and the exchange rate began to be increasingly market
determined. The RBI was able to move away from direct instruments to indirect market-based
instruments in its liquidity management operations. By 1997, Cash Reserve Ratio (CRR) and
Statutory Liquidity Ratio (SLR) were brought down. RBI broadly followed the monetary targeting
rule from mid-1980s till around 1997-98.

In April 1998, RBI adopted a ‘multiple indicator approach’ with greater emphasis on interest rate
and exchange rate channels for monetary policy transmission, relative to quantity instruments.
Under the multiple indicator approach, which is currently in use, a number of variables such as
money, credit, output, merchandise trade, capital flows and fiscal situation as well as interest rates,
rates of return in different financial markets, inflation rate and exchange rate are analyzed for
drawing monetary policy inferences. The RBI also introduced the Interim Liquidity Adjustment
Facility (ILAF) in April 1999, under which liquidity injection was done at the bank rate and
liquidity absorption was through fixed reverse repo rate. The ILAF gradually transitioned into a
full-fledged liquidity adjustment facility (LAF) that was operated through overnight fixed rate repo
and reverse repo from November 2004 onwards. The LAF helped to develop interest rate as an
instrument of monetary transmission. In the process, two major weaknesses were revealed in the
functioning of monetary policy. First was lack of a single policy rate. The operating policy rate
alternated between repo and reverse repo rates depending upon the prevailing liquidity condition.
In a surplus liquidity condition, the operating policy rate was the reverse repo rate, while in a
deficit liquidity situation it was the repo rate. Second was the lack of a firm corridor. The overnight
interest rates dipped below the reverse repo rate in surplus conditions and rose above the repo rate
in deficit conditions. Moreover, overnight call rates became unbounded under occasional liquidity
stress. Thus, more often the overnight interest rate remained outside the corridor.

In May 2011, the RBI announced a revised monetary policy operating procedure based on the
recommendations of a committee constituted for the purpose. The new operating procedure
retained the essential features of the LAF framework with a few key modifications. • First, the
weighted average overnight call money rate was explicitly recognized as the operating target of
monetary policy. • Second, the repo rate was made the only one independently varying policy rate.
• Third, a new Marginal Standing Facility (MSF) was instituted under which scheduled
commercial banks (SCBs) could borrow overnight at their discretion up to 1% of their respective
NDTL (banks’ net demand and time liabilities) at 100 basis points above the repo rate. • Fourth,
the revised corridor was defined with a fixed width of 200 basis points. The repo rate was placed
in the middle of the corridor, with the reverse repo rate 100 basis points below it and the MSF rate
100 basis points above it. The new operating framework with the modified LAF presupposes the
dominance of the interest rate channel of monetary transmission. This implies that once the RBI
changes the policy repo rate, it should immediately impact the overnight interest rate, which is the
operational rate and then transmit through the term structure of interest rates as well as bank
lending rates.

In January 2014, the Expert Committee to Revise and Strengthen Monetary Policy Framework
under the chairmanship of Dr. Urjit Patel (henceforth Urjit Patel Committee Report (UPCR)) made
several important recommendations related to the conduct of monetary policy in India. These
include
(a) Using the Consumer Price Index (CPI) inflation as the nominal anchor for monetary policy
communication;
(b) moving towards an inflation targeting regime over the next two years with a target of 4% within
a band of ±2%; and
(c) setting up a five member Monetary Policy Committee, which will be responsible for making
policy decisions, and be held accountable in case of failure to meet the nominal target.

In India, there has been a long-standing debate on the benefits and costs involved with a move
towards inflation targeting. HPEC (2007), also known as Percy Mistry Committee Report, strongly
advocated a move towards inflation-targeting pointing out associated benefits including fiscal
stability and low output volatility. It also argued that an institutional commitment to predictable
and low inflation would reduce risks from capital flight as value of the Rupee would be maintained
in real terms and expectations about its future values would be stable. While it advocated the use
of Consumer Price Index (CPI) inflation as the nominal target, it pointed out the necessity to cease
subsidization of key prices and intervention in the commodity markets through price measures.
Similarly, Planning Commission (2011) argued for reorientation of monetary policy towards price
stability or low and stable inflation, although the report does highlight the deflationary cost
associated with bringing down inflation from high levels and to build credibility for a central bank
that has lacked inflation fighting credentials. Shah (2014) argues that every currency needs a
nominal anchor as otherwise a country might end up printing too much ‘fiat money’, and that a
foreign currency and CPI basket are the possible choices for nominal anchor. Of these, pegging to
a foreign currency results in loss of monetary independence, and can lead to costly crises as
witnessed in East Asia in 1997. In contrast, targeting inflation provides a durable long-term
solution.

In sharp contrast, Subbarao (2009) points out that “… inflation-targeting is neither desirable nor
practical in India for a number of reasons.” These include (a) the need of a central bank of a
developing country being guided by price stability, financial stability and growth; (b) food items
continue to be vulnerable to supply shocks, especially because of vagaries of monsoon, and are
beyond the ambit of monetary policy; (c) inefficient transmission mechanism due to large fiscal
deficits, presence of administered prices and interest rates and illiquid private bond market; and
(d) managing volatility of exchange rate in the face of disorderly capital flows.

Urjit Patel Committee Recommendations:

The UPCR argues for the adoption of an inflation targeting regime, under which the objective is
to achieve the inflation target on average over the business cycle. The report points out that by
predominantly focusing on price stability, an inflation targeting regime anchors inflation
expectations, improves overall macroeconomic stability, and enhances growth prospects in the
medium run. At the same time, an inflation targeting regime allows the inflation to deviate from
the target in the short run to accommodate growth concerns. The UPCR favours domestic inflation
as the nominal anchor over other historically used measures such as the exchange rate and
monetary aggregates. While using the former as the nominal anchor involves relinquishing
monetary policy independence and makes the monetary policy framework susceptible to
speculative attacks and currency crisis, the use of latter can be undermined by instability and loss
of predictability of the demand for money, thereby discrediting accountability and communication
when targets are missed. In contrast, using domestic inflation as the nominal anchor makes price
stability the unambiguous and sustainable objective upon which the private sector can anchor
future inflation expectations. It also has the advantage of being simple and easily communicable,
and thereby well understood by the public. However, focusing exclusively on inflation also has its
disadvantages. First, certain components of inflation such as food and fuel cannot be directly
controlled by the monetary policy. Second, the long and variable lags in monetary policy
transmission makes targeting inflation a medium term approach. Finally, overarching emphasis on
achieving the targeted inflation can adversely impact growth and employment prospects.

The UPCR favours the use of the all India Consumer Price Index Combined inflation against the
traditional Wholesale Price Index (WPI) inflation as the inflation metric. This is primarily driven
by the CPI Combined index capturing price movements in service sectors, which accounts for
nearly two-thirds of GDP. This index is also subject to marginal revisions, critical for policy
formulations as large revisions result in uncertainty in the assessment of inflation conditions.
Moreover, CPI Combined has the advantage of capturing more accurately the true inflation that
the consumer faces in the retail market. On the choice of headline versus core inflation, UPCR
shows a preference for headline inflation, including food and fuel inflation. The latter tends to have
an important bearing on aggregate inflation expectations as it gets manifested in the inflation of
other items with a lag. Moreover, UPCR also notes that shocks to food and fuel inflation have a
larger and more persistent impact on inflation expectations compared to non-food inflation. At the
same time, the construction of the consumption basket makes it difficult to completely isolate the
impact of food and fuel inflation. Exclusion of food and fuel inflation results in discarding around
57 percent of the consumption basket. However, even with the exclusion of food and fuel inflation,
other components of the consumption basket such as transport and communication are impacted
by change in diesel and petrol prices, and further segregation is not possible as item level
disaggregated price index is not available. For these reasons the UPCR focuses on CPI Combined
inflation recognising that a part of the inflation would be outside the ambit of the monetary policy.
In selecting a numerical target, the UPCR relies on both comparator emerging market economies
as well as India’s historical experience. The literature points out that while in advanced economies
an inflation rate of 1 percent to 3 percent is viewed as acceptable, in emerging markets, acceptable
inflation rate tends to be around 4 percent to 5 percent. Using empirical methods, the report finds
that during the period from 2003-04 Q3 to 2006-07 Q1, when India’s output gap was fairly close
to zero, CPI inflation averaged 4 percent. Similarly using quarterly data from 1996-97 to 2012-13,
the report finds CPI-Combined inflation of above 6.2 percent is inimical to growth. Based on this
analysis, UPCR recommends that the nominal anchor should be set at 4 percent with a band of ±2
percent around it. The UPCR stipulates a period of two years to achieve the inflation target. This
is based on the costs imposed by high inflation in the form of real effective exchange rate (REER)
appreciation, high current account deficit, erosion of financial savings and resultant decline in
financial saving and investment that hampers growth.
The UPCR also lays down some of the key changes in the institutional framework required to
undertake a successful transition to an inflation targeting regime. A key precondition is to follow
a path of fiscal consolidation so that a loose fiscal policy does not impede the monetary
transmission. The report also recommends the elimination of various administered prices, wages
and interest rates that hinder the smooth transmission of monetary policy.

Is inflation targeting desirable?

Over the past few decades, policy makers throughout the world have become increas- ingly
aware of the social and economic costs of inflation and more concerned with maintaining
a stable price level as a goal of economic policy. Indeed, price stability, which central
bankers define as low and stable inflation, is increasingly viewed as the most important
goal of monetary policy. Price stability is desirable because a rising price level (inflation)
creates uncertainty in the economy, and that uncertainty might hamper economic growth.
For example, when the overall level of prices is changing, the information conveyed by the
prices of goods and services is harder to interpret, which complicates decision making for
consumers, businesses, and government, thereby leading to a less efficient financial system.

Not only do public opinion surveys indicate that the public is hostile to inflation, but a
growing body of evidence also suggests that inflation leads to lower economic growth. The
most extreme example of unstable prices is hyperinflation, such as Argentina, Brazil, and
Russia have experienced in the recent past. Hyperinflation has proved to be very damaging
to the workings of the economy.

Inflation also makes it difficult to plan for the future. For example, it is more difficult to
decide how much to put aside to provide for a child’s college education in an inflationary
environment. Furthermore, inflation can strain a country’s social fabric: Conflict might
result, because each group in the society may compete with other groups to make sure that
its income keeps up with the rising level of prices.

While price stability is the primary goal of most central banks, five other goals are
continually mentioned by central bank officials when they discuss the objectives of
monetary policy: (1) high employment, (2) economic growth, (3) stability of financial
markets, (4) interest-rate stability, and (5) stability in foreign exchange markets.

In the long run, there is no inconsistency between the price stability goal and the other
goals mentioned earlier. The natural rate of unemployment is not lowered by high inflation,
so higher inflation cannot produce lower unemployment or more employment in the long
run. In other words, there is no long-run trade-off between inflation and employment. In
the long run, price stability promotes economic growth as well as financial and interest-
rate stability. Although price stability is consistent with the other goals in the long run, in
the short run price stability often conflicts with the goals of high employment and interest-
rate stability. For example, when the economy is expanding and unemployment is falling,
the economy may become overheated, leading to a rise in inflation. To pursue the price
stability goal, a central bank would prevent this overheating by raising interest rates, an
action that would initially lower employment and increase interest-rate instability. How
should a central bank resolve this conflict among goals?

Because low and stable inflation rates promote economic growth, price stability should be
the primary long-run goal of monetary policy. Nevertheless, because output fluctuations
should also be a concern of monetary policy, the goal of price stability should be seen as
the primary goal only in the long run. As long as price stability is a long-run goal, but not
a short-run goal, central banks can focus on reducing output fluctuations by allowing
inflation to deviate from the long-run goal for short periods of time.

Inflation targeting has become the most common monetary policy strategy that coun- tries
use to achieve price stability. New Zealand was the first country to formally adopt inflation
targeting in 1990, followed by Canada in 1991, the United Kingdom in 1992, Sweden and
Finland in 1993, and Australia and Spain in 1994. Israel, Chile, and Brazil, among others,
have also adopted a form of inflation targeting

Advantages of Inflation Targeting

Inflation targeting has the key advantage that it is readily understood by the public and is
thus highly transparent. Also because an explicit numerical inflation target increases the
accountability of the central bank. A key advantage of inflation targeting is that it can help
focus the political debate on what a central bank can do in the long run—that is, control
inflation, rather than what it cannot do, permanently increase economic growth and the
number of jobs through expansionary monetary policy. Thus, inflation targeting has the
potential to reduce political pressures on the central bank to pursue inflationary monetary
policy and thereby to reduce the likelihood of the time-inconsistency problem.

Inflation-targeting regimes also put great emphasis on making policy transparent and on
regular communication with the public. Inflation-targeting central banks have frequent
communications with the government, some mandated by law and some in response to
informal inquiries, and their officials take every opportunity to make public speeches on
their monetary policy strategy.

The above channels of communication are used by central banks in inflation- targeting
countries to explain the following concepts to the general public, financial market
participants, and politicians: (1) the goals and limitations of monetary policy, including the
rationale for inflation targets; (2) the numerical values of the inflation targets and how they
were determined; (3) how the inflation targets are to be achieved, given current economic
conditions; and (4) reasons for any deviations from targets. These communications have
improved private-sector planning by reducing uncertainty about monetary policy, interest
rates, and inflation; they have promoted public debate of monetary policy, in part by
educating the public about what a central bank can and cannot achieve; and they have
helped clarify the responsibilities of the central bank and of politicians in the conduct of
monetary policy.

Another key feature of inflation-targeting regimes is the tendency toward increased

accountability of the central bank. Indeed, transparency and communication go hand in
hand with increased accountability. The strongest case of accountability of a central bank
in an inflation-targeting regime is in New Zealand, where the government has the right to
dismiss the Reserve Bank’s governor if the inflation targets are breached, even for one
quarter. In other inflation-targeting countries, the central bank’s accountability is less
formalized. Nevertheless, the transparency of policy associated with inflation targeting has
tended to make the central bank highly accountable to the public and the government.
Sustained success in the con- duct of monetary policy as measured against a preannounced
and well-defined inflation target can be instrumental in building public support for a central
bank’s independence and for its policies. This building of public support and accountability
occurs even in the absence of a rigidly defined and legalistic standard of performance
evaluation and punishment.

The performance of inflation-targeting regimes has been quite good. Inflation-targeting

countries seem to have significantly reduced both the rate of inflation and inflation
expectations beyond what would likely have occurred in the absence of inflation targets.
Furthermore, once down, inflation in these

Disadvantages of Inflation Targeting

Critics of inflation targeting cite four disadvantages of this monetary policy strategy:
delayed signaling, too much rigidity, the potential for increased output fluctuations, and
low economic growth. We look at each in turn and examine the validity of these criticisms.

1. Delayed Signaling Inflation is not easily controlled by the monetary authorities,

and because of the long lags in the effects of monetary policy, inflation outcomes
are revealed only after a substantial lag. Thus, an inflation target is unable to send
immediate signals to both the public and markets about the stance of monetary
policy.
2. Too Much Rigidity Some economists have criticized inflation targeting because
they believe it imposes a rigid rule on monetary policy makers and limits their ability
to respond to unforeseen circumstances. However, useful policy strategies exist that
are “rule-like,” in that they involve forward-looking behavior that limits policy
makers from systematically engaging in policies with undesirable long-run
consequences. Such policies avoid the time-inconsistency problem and would best
be described as “constrained discretion.”
 Indeed, inflation targeting can be described exactly in this way. Inflation targeting,
as actually practiced, is far from rigid and is better described as “flexible inflation
targeting.” First, inflation targeting does not prescribe simple and mechanical
instructions on how the central bank should conduct monetary policy. Rather, it
requires the central bank to use all available information to determine which policy
actions are appropriate to achieve the inflation target. Unlike simple policy rules,
inflation targeting never requires the central bank to focus solely on one key variable.
Second, inflation targeting as practiced contains a substantial degree of policy
discretion. Inflation targets have been modified depending on economic
circumstances, as we have seen. Moreover, central banks under inflation-targeting
regimes have left themselves considerable scope to respond to output growth and
fluctuations through several devices.
3. Potential for Increased Output Fluctuations An important criticism of
inflation targeting is that a sole focus on inflation may lead to monetary policy that
is too tight when inflation is above target and thus may lead to larger output
fluctuations. Inflation targeting does not, however, require a sole focus on
inflation—in fact, experience has shown that inflation targeters display substantial
concern about output fluctuations. All the inflation targeters have set their inflation
targets above zero. For example, currently New Zealand has the lowest midpoint for
an inflation target, 1.5%, while Canada and Sweden set the midpoint of their
inflation target at 2%; and the United Kingdom and Australia currently have their
midpoints at 2.5%.
The decision by inflation targeters to choose inflation targets above zero reflects the
concern of monetary policy makers that particularly low inflation can have
substantial negative effects on real economic activity. Deflation (negative inflation
in which the price level actually falls) is especially to be feared because of the
possibility that it may promote financial instability and precipitate a severe
economic contraction. The deflation in Japan in recent years has been an important
factor in the weakening of the Japanese financial system and economy. Targeting
inflation rates of above zero makes periods of deflation less likely. This is one
reason why some economists, both within and outside of Japan, have been calling
on the Bank of Japan to adopt an inflation target at levels of 2% or higher. Inflation
targeting also does not ignore traditional stabilization goals. Central bankers in
inflation-targeting countries continue to express their concern about fluctuations in
output and employment, and the ability to accommodate short-run stabilization
goals to some degree is built into all inflation-targeting regimes. All inflation-
 targeting countries have been willing to minimize output declines by gradually
lowering medium- term inflation targets toward the long-run goal.
4. Low Economic Growth Another common concern about inflation targeting is that
it will lead to low growth in output and employment. Although inflation reduction
has been associated with below-normal output during disinflationary phases in
inflation-targeting regimes, once low inflation levels were achieved, output and
employment returned to levels at least as high as they were before. A conservative
conclusion is that once low inflation is achieved, inflation targeting is not harmful
to the real economy. Given the strong economic growth after disinflation in many
countries (such as New Zealand) that have adopted inflation targets, a case can be
made that inflation targeting promotes real economic growth, in addition to
controlling inflation.