Monetary Policy Committee (MPC) and inflation targeting

What is the Need for Inflation Targeting?

• Inflation targeting advocates the objective of price stability in actual monetary policy arrangement.
• Adopting price stability as a primary objective creates a stable non-inflationary environment for resource allocation.
• Inflation targeting will stabilize price expectations which are an essential requirement to keep in control the volatility of price changes.

Factual Figures of Demonetization

• With respect to Demonetization, varied views are being asserted with regard to its impact on the overall economy.
• Demonetization has happened on November, 2016 and it was expected that growth figures will fall in the third quarter of the year, but the growth figures held up quite well in Q3 as compared to the previous quarter.
• However it was noticed that growth figure, measured by Gross Value Added (GVA) in the fourth quarter declined as compared to quarter 3.
• Another noticeable point is that the growth in GVA for the year as a whole, was in line with the estimates made prior to demonetization.
• There has been a fall in GDP growth from 8% in 2015-16 to 7.1% in 2016-17

MPC and Demonetization

• MPC in its 7^th December, 2016 meeting stated that demonetization is a temporary phenomena and expected inflation and growth to follow a “V” shaped pattern i.e. both the inflation and growth would decrease sharply and then will rise, which actually hasn’t happened.
• Now GDP growth is at flat and inflation has followed just the first half of the “V”.
• MCP’s post demonetization inflation forecast for March 2017 was 5% with an upward bias whereas as actual March 2017 CPI Inflation was – a low 3.5% and actual April 2017 CPI Inflation was 3%.
• Thus the forecast of the three month projection shows a huge error.
• MPC’s prime mandate was to target headline inflation and now is considering targeting core inflation.
• Another point of contradiction has aroused between the views of the RBI and the Chief Economic Advisor – Arvind Subramanyam.
• According to Subramanyam, last year saw a deceleration in manufacturing sector and there is a strong need of macro policy support whereas RBI in its monetary policy report noted that manufacturing sector has gained momentum in the second half of 2016-17.
• With regard to growth, RBI has stated that growth is recovering of its own accord which is not quite true. And even if it is recovering, it would be below the output potential of the economy. So RBI needs to cut interest rates in order to support growth
• But growth is not the primary mandate of the RBI today. The primary mandate is keeping inflation within a targeted band of 4% plus or minus 2%. But MCP has made as shift and now states that it only needs to ensure that inflation stayed with the overall band.

Challenges Faced by MPC

• The RBI and the MPC are facing this problem of huge gap in forecasting. As of April, inflation is at well-disposed level of 3%.
• Thus there is a continuous mismatch between the actual inflation rate and the one forecasted by the MPC.
• Most of the treasury bills rates are below the RBI’s overnight policy rate, which implies that there is a lot of liquidity in the economy.
• For the RBI and the MPC which has fixed its view towards inflation, a fall in the rate of the overnight questions the credibility
• With such levels of liquidity, inflation figure will not follow a “V” pattern and will remain strikingly low only.
• To be consistent with the statement that MPC has provided post-demonetization, the central bank ought to drain liquidity probably by raising the cash reserve ratio.
• If thought in terms of financial stability, using the CRR weapon can have adverse consequences on both inflation and growth rate.
• Already the unexpected shift of stance from accommodative to neutral in February has led to losses in the investment book for many banks.
• Earlier the MPC clearly prescribed the level at which inflation is to be maintained, but now by maintaining no change in the repo rate it has taken a neutral stand.
• Thus not following an accommodative policy, it has signaled that there will be no rate cuts in the near term.
• Investment and rate of interest are negatively related. A non-accommodative stance is already causing losses in terms of prospective investments.
• Absolutely different from this, for a government that is keen to push growth, a cut in the policy rate would help repair the balance sheets of banks and corporate and reverse the fall in the investment rate.
• It would further boost consumption. However, the RBI’s commitment to an inflation target of 4% renders a rate cut difficult.
• Apart from the policy related issues, RBI and MPC has failed miserably in meeting its own set standards of communication and reporting.
• In a highly regressive move beginning in October, the transcripts and recordings of the post-policy briefings with researchers are no longer being uploaded on the RBI’s website. No explanation has been offered.

Possible Solutions

• One ideal way to drain liquidity, as many experts have been pointing is for RBI to introduce a standing deposit facility into which banks can deposit cash without the RBI having to provide government securities as collateral. However, this will require a legislative change because under current rules RBI cannot accept uncollateralised money.
• The other option it has is to lower the reverse repo rate and expand the corridor between the repo and the reverse repo rate. This will automatically make the yield curve look less out of sync.
• But doing this will again pose two serious challenges – (a) Treasury Bills will still be below the RBI’s overnight lending rate and (b) A rate cut will ill fit with the recent hawkish twist to the MPC’s stance.
• If the RBI wishes to do its bit to boost growth, there is only one way out. It must avail of the flexibility it has been provided under the inflation mandate.

Suggestions for Improvement

• The immediate action that the RBI and the MCP needs to consider is this – improving the forecasting analysis that it is making and at the same time not setting up rigid goals for itself.
• There is an urgent requirement to clear the air on its definition of core inflation despite its legal mandate for headline consumer price index (CPI) inflation. The MPC/RBI must address the criticism that its preferred core measure (i.e. CPI ex-food and fuel) is incomplete as it excludes transportation, thereby overstating core inflation.
• The inflation outlook also needs to be assessed in the context of potential reflationary policies for the agriculture and rural sectors.

What happened in the last RBI/MCP meet?

• The Reserve Bank of India has kept repo rate unchanged at 6.25% in its second bi-monthly monetary policy review.
• Reverse Repo rate has been kept unchanged
• The RBI has cut the Statutory Liquidity Ratio (SLR) by 50 basis points to 20%
• RBI has projected the headline inflation in the range of 2.0-3.5% in the first half of 2017-18 and 3.5- 4.5% in the second half.
• RBI has reduced the growth projection for the current fiscal to 7.3% from 7.4%.