How RBI Paved Way For Inflation Targeting

As the RBI’s monetary policy meeting is underway, all stakeholders are keenly watching what key decisions will be taken by the Central Bank on October 4.  But how the monetary policy of the central bank has changed with the passage of time. Let’s peep into the history, how the monetary policy’s target and approach have changed in the past.

During November 1997 to September 2017, RBI’s approach to monetary policy during was characterised as a “multiple indicators approach”. Inflation was, of course, a key element among other variables that were included under the multiple indicator approach. 

Y. Venugopal Reddy, Governor, RBI, during 2003 to 2008 indicated, described his approach to inflation at that time as “self-imposed, indicative inflation targeting, consistent with global trends, and the compulsions of maintaining growth momentum” 

Why Wasn’t Inflation Targeting Adopted Earlier? 

Comparing India with other developing countries had a record of moderate inflation, with double-digit inflation being the exception. For example India has witnessed double digit inflation only four times since 2010. In June 2010, the consumer price index stood at whooping 13. 9 per cent, in August 2010 this slightly to reduced 13.7 per cent and in September the same year the inflation was 11.3 per cent. After a few years country witnessed inflation rate of 11.24 per cent in December 12, 2013.

Inflation targeting has been especially useful in countries that have experienced high inflation prior to the adoption of inflation targeting. Most importantly till very recently India did not have a pan-India consumer price index (CPI).

Inflation Targeting in Monetary Policy

The talks about inflation targeting in India started in the late 1990s and the discussion gained momentum after the Reserve Bank of New Zealand’s Dr Donald T Brash, delivered a speech during the L. K. Jha memorial lecture series on 17 June 1999 in Mumbai on how New Zealand’s experience with IT can be relevant for developing countries. 

Narasimham (2000) and Rajan (2007) Committees recommended the implementation of Inflation Targeting, with a fixed medium term target, in India. The Raghuram Rajan Committee on Financial Sector Reforms was a committee constituted by the Government of India in 2007 for proposing the next generation of financial sector reforms in India. They felt that currently RBI does not have a clear objective and the inflation rates are residuals of various policies.

The emphasis on inflation targeting appeared officially for the first time in the Report of the Committee on Financial Sector Reforms (CFSR), constituted by the Government of India (Planning Commission) and chaired by Raghuram Rajan then Professor at University of Chicago.

The Committee argued that the RBI “can best serve the cause of growth by focusing on controlling inflation”, and explicitly recommended, “

However, the emergence of sustained double-digit inflation (and enhanced inflation expectations) between 2009 and 2013 garnered more and more support for the adoption of inflation targeting. 

According to Narasimham Committee and Rajan Committee, maintaining a low and stable inflation, would automatically lead to a stable GDP growth. This in turn would allow households and firms to make long term decisions confidently, leading to an increase in investments and allowing RBI to take monetary policy decisions beneficial to long term growth and employment. 

Rajan further argued that in a country like India, where inflation is not extremely high, and the central bank is considered reasonably credible by the public, focusing on inflation should not lead to a loss in output growth. Narasimham Committee felt that if the RBI is successful at achieving inflation target, a low inflation rate would contribute to exchange rate stability as well.

In his first speech as RBI Governor, Rajan (Reserve Bank of India, 2013) emphasized on the importance of inflation targeting and set up an Expert Committee under Deputy Governor Urjit Patel to assess the current monetary policy and give recommendations to strengthen it. 

After considerable discussion a Monetary Policy Framework Agreement (MPFA) was finally signed between the Government of India and the RBI on February 20, 2015, specifying the following: 

• Government has set a target for RBI to bring down inflation below 6 per cent by January 2016, 4 per cent for financial year and all subsequent years with band of +/- 2 per cent. 

• If RBI fails to meet the target, it will report to the government with the reasons for the failure to achieve the target and propose remedial actions to be taken. 

• The RBI will further estimate the time period within which the failed target would be achieved. Flexible inflation targeting was formally adopted in India with the signing of the MPFA.

Subsequently, the RBI Act was amended on May 14, 2016 to give the key provisions in the MPFA a statutory basis. This inflation target set by the Urijit Patel committee is applicable for the period from August 5, 2016 to March 31, 2021. 

The RBI started publishing a bi-annual Monetary Policy Report from September 2014, which provides forecasts of inflation and growth as well as an assessment of the overall macroeconomic conditions. Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary policy with experts however, its role was only advisory in nature. With the formation of MPC, the TAC on Monetary Policy ceased to exist. 

Now, the MPC determines the policy interest rate required to achieve the inflation target. The voting pattern of the MPC meetings and the minutes reveal an interesting regularity. There was complete unanimity among the members in the first four meetings but there has been evidence of some dissent from the majority view (in both directions) since then.