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Is RBI better or worse off with inflation targeting, MPC?

Over the past 15 days, a slew of developments have taken place that has brought into focus the Indian central bank’s autonomy.

On February 20, the government and the Reserve Bank of India signed a monetary policy agreement that gave the latter the task of keeping inflation below 6 percent until January 2016 and bring it down to 4 percent by January, 2018.

On February 28, in the Budget, the government failed to keep the fiscal deficit to the pre-agreed limit of 3.6 percent for FY16. Yet, on March 4, the Reserve Bank provided an out-of-turn [outside the monetary policy review meeting] rate cut justifying it partly on grounds of declining inflation and partly because though the deficit is higher than the target, the quality of the number is better.

The Budget also transferred the power of making policies on equity-related capital controls from the Reserve Bank to the government. While the government securities market regulation has also mostly moved to Securities and Exchange Board of India (SEBI) from the RBI.

Finally, monetary-policy making will soon be done by a monetary policy committee (MPC) and in the days to come, we will know how that committee is to be constituted.

In an interview with CNBC-TV18’s Latha Venkatesh, former RBI governors Dr Bimal Jalan and Dr C Rangarajan, Business Standard editor AK Bhattacharya and JP Morgan economist Sajjid Chinoy, who was a member of the Urjit Patel Committee (the author of the monetary policy framework and agreement), discuss whether the central bank is better off or worse following the recent developments.

Below is the transcript of the interview on CNBC-TV18.

Latha: First of all let me look at just the rate cuts and go from the micro to the macro. We hardly ever hear of the Fed giving an out of turn rate cut, rate cuts are always given on policy days; we hardly hear of the European Central Bank (ECB) doing that. Does it tarnish the RBI’s image if it makes regular out-of-turn rate cuts?

Rangarajan: As you know that the RBI used to have only two meeting in a year and monetary policy changes were announced all through the year. Therefore this bi-monthly monetary policy statement is a new phenomenon; it has not been there all along in the Reserve Bank also.

Therefore in some sense binding oneself to certain point in time is not a good thing, the monetary authority should be able to act whenever it feels there is a need for it but how having created such a system, sometimes these out-of-turn policy decisions do come as a surprise. I certainly thought that the latest move came as a surprise to me. Not necessarily the measure but the timing of it.

Latha: Is there an issue in this that you get into a framework where you say that my part of the bargain is I’ll deliver 6 percent. All along, the RBI has correctly maintained that high fiscal deficit has caused inflation and the government does not adhere to its set target, a target which was even reinforced by the Finance Commission, a constitutional body, and the two days after that, the RBI makes a rate cuts. Does not that give the impression that there was pressure on them?

Bhattacharya: I do not know whether there was any pressure or not but there were enough signals from North Block to the RBI. Even if you look at the many comments that came after the Budget and just before the rate cut actually was announced. So, there were enough signals to the RBI that it is time to cut rates. So, to that extent you are absolutely right, there may not have been any pressure but there were enough signals and when those signals come from as important and as significant a player as the Ministry of Finance, I would imagine that signal would be taken little more seriously than your or my signal.

On the point that you raised about the fiscal policy thing and RBI of has tried to justify why the rate cut was necessary because that the quality of fiscal deficit, if you take the states’ fiscal deficit and the centre’s fiscal deficit together, there will be some sort of reduction. And the rating agencies as well as the investing community always look at the total — centre and the state’s combined fiscal deficit where you will see some reduction.

Latha: There is also a point that the estimates this time are more real. But from a global investor’s perspective — while a real and persistent danger always merits action out of turn but to stimulate the economy, how does an out-of-turn rate cut gel with other central bankers’ standards? And more importantly, when the fiscal deficit target, the headline target has not met a preset expectation?

Chinoy: We need to look at the economic situation more holistically here. The context here is the RBI needs to be driven by the economic calendar, not by the lunar calendar. And economic conditions suggest this by the RBI’s own inflation forecast as recently as for months ago headline inflation was going to be 8 percent. We are 300 basis points below your own forecast and that is what is driving the urgency.

So, let me pose the question this way: what if the Fed found out that inflation was a couple of hundred basis points below its own forecast? You would see more urgencies from the Fed so, you have to understand the January move and the March move in the context that inflation has fallen so much that even if there is some slippage on the fiscal deficit, it does not offset the other disinflationary forces.

So, lets’ give them the benefit of the doubt. I agree we should not make this a habit but economic conditions today are quite unique that some out of cycle cuts are not that unwarranted.

Latha: Let me come to the more important question, the framework itself. The monetary policy framework, it says that RBI’s primary responsibility is to keep inflation below 6 percent. Is this inhibiting or is this autonomy enhancing? For instance if the RBI were to notice asset bubbles in the housing market or even in the stock market like was the case in 2007 where inflation was fairly under control, can it act? Does the framework actually inhibit it?

Jalan: My view on inflation targeting is different from what the accepted view is. I do not think an inflation targeting is a good idea. I know n number of countries have adopted it, others have adopted it but inflation targeting per se in our kind of an economy where food prices are very important, CPI inflation is the target and also the trade-off between growth and inflation is extremely important at different points of time.

This is a very personal point that I do not believe in inflation targeting per se but central banks across the world have adopted inflation targeting but we had avoided it for quite some time, and I am sure Dr.Rangarajan would have more to say on it but these views are different so I do not want to express a view on whether inflation targeting should be this or that.

But I just believe that the most important thing is low inflation, good growth and as long as the two are consistent, we do not have to worry about whether it is 4.2 or 4.3 or 3.9. I do not believe in this first decimal point.

Latha: You had earlier on my show said that it is an autonomy-enhancing framework but what if financial stability is under threat though the inflation numbers immediately don’t give that impression? Will this prevent the Reserve Bank from working?

Rangarajan: My interpretation of inflation targeting is slightly different. What inflation targeting demands from the central bank is that when inflation is outside the comfort zone particularly on the upper side, then the central bank — the RBI in the present case — should decisively act.

But when inflation is within the comfort zone other objectives also come in to play. My point is that the Fed misinterpreted this and Fed when it found that inflation is low but when there were other factors in the economic system which demanded certain treatment they did not do it.

My interpretation is that within the comfort zone that if there are other factors, which point towards taking a hard stand, it can be taken. But the most important thing is that when inflation is running above the comfort zone, the RBI must act decisively. That is the correct interpretation of inflation targeting.


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