The art and science of managing inflation

News: In recent weeks, the conduct of monetary policy in India has been severely criticized by economists.

About the Monetary Policy Committee

The primary objective of the Monetary policy Committee is its flexible inflation-targeting mandate.

What have been the lacunas in MPC policies?

One, there has been an unnecessary delay in changing priorities from supporting growth to controlling inflation.

Two, in addition to balancing the inflation-growth trade-off, the MPC policy has been pursuing multiple objectives. Therefore, it resulted in the loss of focus on the primary objective, leading to persistently high inflation.

What are the underlying challenges in the conduct of monetary policy?

First, on inflation targeting. Monetary policy is always based on forecasts. The consumer price index inflation forecast moved lower from 4.9% in the September 2021 round to 4.7% in January 2022. However, when the geo-economic impacts of the Ukraine crisis on commodities and energy prices were factored into, it resulted, the inflation forecast jumped to 5.2 percent. Thus, there is an uncertainty in inflation targeting.

The second concern is the fiscal dominance of monetary policy. The transmission of monetary policy signals into the spectrum of interest rates is varied, with each rate having different behavioral, regulatory, and structural causes for the changes as well as functional impacts.

A third concern is whether RBI’s “management” of the rupee has been distracting from the primary objective of price stability.

In reality, at present, India is facing an episode of the open economy impossible trinity. For example, there is a global spill-over effect of G-10 central bank actions. It definitely requires foreign exchange intervention.

What should be the priority areas of the monetary policy?

(1) Conventional Focus

Globally, the role of monetary policy has been to fix the policy rate in order to ensure macroeconomic stability. Further, the rest of the yield curve was allowed to be moved based on market and economic conditions. In fact, the monetary policy was not involved in an attempt to control the slope and curvature.

(2) Focus areas at present

Since the global financial crisis, the conventional framework has been mostly abandoned. Now, monetary policy works through various instruments like quantitative easing, yield curve control, etc. to change the structure of the yield curve.

In India too, the RBI had deployed programs like targeted long-term repo operations, G-sec Acquisition Programme over and beyond normal open market operations to influence the yield curve at selected maturities, during the pandemic phase.

Source: The post is based on the article “The art and science of managing inflation” published in the Business Standard on 28^th June 2022.