India’s monetary policy framework: Let’s go from good to great

The Fed, in its Revised Statement on Longer-Run Goals and Monetary Policy Strategy released on 22 August, declared its intent to continue with its 2% inflation target. Likewise, RBI, in its Discussion Paper Review of Monetary Policy Framework released a day earlier, argues strongly in favour of retaining the core principles of the existing framework.

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In parallel with the Fed’s desire to “give the public a clear sense of how the Fed thinks about monetary policy, given that such understanding is important both for transparency and accountability, and for making monetary policy more effective," RBI sees the review as “an opportunity to revisit some of the basic tenets of the framework to nudge the economy towards further improved macroeconomic outcomes in the best interest of all stakeholders."

This is a good beginning; a welcome change from the central bank’s usual ivory-tower approach. Remember, the first review in 2021 was done away from the public eye. But it is not enough. RBI must try and reach out to a wider audience on the lines of ‘Fed Listens’ events in the US, where Fed officials engage with a wide cross-section of the public, including the hoi polloi, to hear how its monetary policy affects their daily lives.

This time around, RBI has sought public feedback on four key questions. One, should monetary policy target headline inflation, as presently mandated under the flexible inflation targeting (FIT) regime introduced in 2016, or core inflation (headline inflation stripped of volatile elements such as food and fuel). Two, whether the current 4% target is optimal for balancing growth with stability in our fast-growing economy. Three, whether the tolerance band of 2-6% needs to be revised—narrowed, widened or dropped altogether. And last, whether the target rate of 4% should be scrapped and only a range be maintained.

Also Read: Monetary policy framework review: RBI must keep inflation firmly in its crosshairs

The discussion paper is clear where RBI’s preferences lie: status quo on all four issues. So, it argues for retaining headline rather than core inflation as the policy target, advocates keeping it at the present 4% level and recommends leaving the margin unchanged at plus or minus 2% of that target. The good thing is that having made its preferences clear, the paper presents both sides of the case, leaving it to the reader to make a judgement.

In the case of targeting core rather than headline inflation, for instance, there is merit in the paper’s take that since food is a significant share of the consumption basket for many Indians, it is meaningless to target core instead of headline inflation.

Moreover, the weight assigned to the food component is anyway expected to decline once India’s consumer price index (CPI) is recast on the basis of the more up-to-date Household Consumption Expenditure Survey 2023-24, as against the 2011-12 survey that’s still in use, an exercise that is already underway.

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The problem is not so much with what the discussion paper says, but what it leaves unsaid. For one, it is silent on the obvious contradiction in the present framework wherein the Monetary Policy Committee (MPC) takes rate decisions but has no say on how RBI manages liquidity. The result is that we often find one working at cross purposes with the other. There have been instances when the MPC raised rates, but then  RBI opened its liquidity tap, negating the impact of the rate action. Since RBI is  currently reviewing its Liquidity Management Framework, it would be good to incorporate it into the Monetary Policy Framework.

That is not all. The present composition of the MPC—three members from RBI and three external members, with the governor given the casting vote—also deserves a rethink. As borne out by past experience, RBI staffers are unlikely to disagree with the governor. And with the latter given the casting vote in the event of a tie, what we have today is a de facto replay of the past, with the governor calling the shots albeit under the guise of collective action.

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Note that a key objective underlying the shift from the governor-centric pre-FIT regime to a rate-setting MPC was to benefit from more diverse opinions. But this is near-impossible in the present system. The MPC should, therefore, be reconstituted so that the governor, like the Fed chair—who is only one of 12 voting members on the Federal Open Markets Committee that sets rates in the US—has only one vote. In the event of a tie, as with the Fed, the status quo should prevail.

Lastly, under the present framework, the Reserve Bank is required to submit a report to the government when the FIT ceiling is breached for three consecutive quarters. But it is not required to make its communication public. So, when the ceiling was breached for five consecutive quarters from the fourth quarter of 2021-22 to the fourth quarter of 2022-23, the Indian public was kept in the dark. In keeping with RBI’s move towards greater openness, this too must change. 

On balance, the FIT regime has served us well. But to paraphrase former British prime minister Winston Churchill, “Never let a good crisis [or review in this case] go to waste." Make it better! 

The author is a senior journalist and a former central banker.