By: Ramesh Kanitkar
Government will soon, in consultation with the Reserve Bank of India (RBI), begin the process of review of the monetary policy framework that was notified on 5 August 2016 and is in place until 31 March next year. Once concluded, the review will lead to a new inflation target for a five-year period beginning April 2021 onwards. The new inflation target would also be accompanied by the Centre nominating three new members to the six-member Monetary Policy Committee (MPC), which determines the policy interest rate required to achieve the targeted rate of inflation. The existing three external expert members of the MPC are Chetan Ghate, Professor, Indian Statistical Institute, Pami Dua, Director, Delhi School of Economics and Ravindra H Dholakia, Professor, Indian Institute of Management, Ahmedabad. The MPC was constituted in September 2016 and provides a tenure of office of four years or until further orders for the external members, with the other three members being the central bank’s Governor, Deputy Governor and one officer of the RBI nominated by its central board.
As per existing norms, the external members are not eligible for reappointment. The formal review process is expected to focus on the achievements of the May 2016 amendment to the RBI Act, 1934 that provided a statutory basis for the implementation of a ‘flexible’ inflation targeting framework — a consumer price inflation target of four per cent inflation with an upper tolerance level of 6 per cent and lower tolerance level of 2 per cent. A growing section of opinion wants a comprehensive review of what has been achieved so far and whether a tweak is required, given the primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. As was expected, the most recent monetary policy review saw the committee keep rates steady, even as the RBI deployed non-monetary instruments to prop up growth.
Given the way inflation targeting works and the unique circumstances and needs of a growing country like India, experts want the Centre and the RBI to undertake a threadbare review to come up with a target that will be credible and sustainable for a five-year period starting April 2021. This is the contentious issue that the Narendra Modi government will have to address over the next few months. Most central banks focus on price stability combined with a focus on growth to decide on the appropriate monetary policy. The two most important instruments of monetary policy are interest rates and money supply. Now stabilisation of prices implicitly implies inflation targeting, whereby a central bank would want inflation to be a specific value or within a range. India’s current monetary policy framework is seen as primarily an “inflation targeting framework”, leading to a section of opinion suggesting that MPC may not have done enough since inflation moderated to record low levels in 2018 until late 2019.
Even the recent spike is driven primarily by food articles and the MPC was correct in maintaining status quo as we need an accommodative monetary policy for the foreseeable future. Given that the monetary policy framework will have a huge impact going forward on an economy that needs urgent growth impetus, an equally important thing that requires urgent attention is the choice of the inflation target. There are many measures of inflation such as the Wholesale Price Index (WPI), the Consumer Price Index (CPI) and the gross domestic product (GDP) deflator. All three of them can give us a different measure of inflation and, therefore, the choice of the target is as important as the target itself. The 2014-16 debate between Raghuram Rajan and Arvind Subramanian was primarily on whether to target WPI or the CPI. Rajan was correct in moving towards the CPI as the preferred target and how this would have an impact on anchoring inflation expectations. The question is whether CPI remains a good indicator in 2020 or not for the simple reason that the NSO’s Consumption Expenditure Survey or CES (2017) has been junked. The 2017 survey was indeed problematic on many grounds as it failed to get even the directional change in consumption making it inconsistent with all other sources of consumption.
Therefore, the government was right in not releasing the report (but it should still release the unit-level data for a serious review of what went wrong with the survey). However, the CES is an important survey as it gives us the relative weights of different items in the consumption basket which are used for CPI computations. To illustrate this point, consider the expenditure on clothing. If in 2011, you spent Rs 100 out of Rs 1,000 on garments, then the share of clothing in your expenditure was 10 per cent. If in 2017, you spent Rs 300 on clothing and your total expenditure is Rs 1,500 then this share is 20 per cent (for simplicity, here assume that we are talking about real expenditure). The current CPI is based on 2011 weights and with an unreliable 2017 data, we cannot update it with 2017 weights and, therefore, we will continue with the old weights in our CPI which can give a higher weight to a lot of items whose share in consumption may have gone either up or down. This has a lot of implications for our estimates of CPI which are very likely to be either overestimated or underestimated, and this poses as a big challenge for our monetary masters who have to formulate policy based on the CPI figures. We may not be able to get a new CPI until the time we have a fresh survey and its results are verified, vetted and released. This implies that we may be making monetary policy based on an inflation indicator that will have a bias. It would be further interesting for academics to study whether this bias has an impact on inflationary expectations as obtained by the RBI or not. Who knows, we may find something interesting there. But, for now, let us recognise that the job of the MPC isn’t going to be easy if it continues with an inflation target that is likely to either under or overestimate inflation. We may need a new target instrument or perhaps start relying on our national accounts data for the relevant weights for different consumption items to update our CPI from time to time. Until the time the quality of our CES surveys don’t improve, perhaps the latter may be a better option. INAV