Inflation and agency accountability

Source: The post is based on the article “Inflation and agency accountability” published in the Business Standard on 27th December 2022. 

Syllabus: GS3- Indian economy 

Relevance: Issues related to the concept of inflation 

News: The article explains the issues related to the inflation-targeting regime in India. It explains the creation of the concept of inflation targeting across the world. 

How have the concepts of inflation targeting and central bank independence developed? 

Fiat money was invented many centuries ago. It was made by the Central Banks. Despite having many advantages, fiat money and Central Banks faced many issues.  

It led to the creation of the thinking that Central Banks should be independent agencies. It should focus on delivering low, stable and predictable inflation.  

Inflation targeting and central bank independence generally worked well. It rapidly spread from one country to the next.  

There is by now enough evidence that economic performance in a country improves after this reform is implemented. 

What led to the formation of the Monetary Policy Committee in India? 

Many committees like Committee on Financial Sector Reforms, 2009 and Financial Sector Legislative Reforms Commission, 2013, chaired by B N Srikrishna suggested an inflation-targeting regime. 

In 2014, Urjit Patel Committee endorsed the idea of inflation targeting and the statutory Monetary Policy Committee. 

The formal announcement on this was made in the first budget speech of the new government in 2014. The Monetary Policy Framework Agreement was signed in February 2015.  

In September 2016, Parliament amended the RBI Act of 1934 for creating a statutory MPC for maintaining price stability. 

How has it worked for the Indian economy? 

Due to limitations of the Indian financial system, inflation targeting would have worked poorly.  

There are important weaknesses in the Indian bond market and banking sector. The bond-currency-derivatives nexus is missing. The monetary policy transmission is therefore weak.  

Hence, RBI can not deliver on a precise inflation target like developed countries. Instead, the RBI was given a wide goalpost. It was delivering inflation in the range from 2 to 6%. 

For some years, this worked well and India achieved price stability. In recent years, though, there are concerns that inflation has regularly surpassed 6%.  

What is the way forward for the inflation-targeting regime? 

Theoretically, there are four possibilities through which a central bank can fail on its target. These are wrong statistics, wrong forecasts, wrong decisions of MPC, and bad transmission of monetary policy. 

Every time there is a failure in achieving the inflation target, India needs to analyse the cause of the failure. Once the cause is found out, we must undertake remedial action.  

This is the task of Parliament. It must review its contract with the RBI and modify the contract in ways that will ensure better performance by the agent.  

It would be useful to have a public release of the RBI’s self-assessment of its failure and its own views on the required remedial measures. The document should be released in the public domain. 

In addition to the RBI report, the models and data and slideshows used in the MPC meeting should be released.  

Each MPC member should be obliged to write and sign a 1000-word rationale statement that explains her voting decision. It will lead to greater individual accountability of MPC members for their voting decision.