Monetary policy framework review must begin

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By: Ramesh Kanitkar

The Governor of the Reserve Bank of India has indicated that an internal review of the monetary policy framework is currently underway. This should be welcomed as the conduct of the monetary policy committee with the current framework has raised a lot of questions that must be addressed. As of now, the RBI has not indicated the terms of reference for the review, but has mentioned that the findings would be shared with stakeholders and academics in order to strengthen the framework going forward. The need to review the framework comes from the fact that for a major part of the MPC’s existence, inflation remained lower than the midpoint of the target band and consequently, our real rates remained higher than the RBI’s estimates of the neutral real rates. Many have highlighted that our monetary policy has been too tight and that too at a time when we needed it to be more accommodative. Therefore, such a review is indeed a welcome change.

However, the success of the review would depend on whether it addresses some critical issues related to the role of monetary policy in the Indian economy. First step of the review should be an acknowledgement of errors made by the MPC rather than blaming the framework which should be followed by a detailed discussion on estimation of India’s neutral real rates. This is important as any change in the idea of neutral real rates will directly impact the conduct of our policy. Another issue is related to the measure of inflation which is based on 2011 weights of the NSO surveys. This will lead to errors in measurement of estimation and any inflation targeting framework is only as good as the measurement of the target instrument. Therefore, to review the monetary policy framework, we must take a step back and look at first principles. The review should also address the issue of the unidimensional focus on inflation and provide a growth target.

A growing economy like India cannot afford to ignore its growth aspirations and this is perhaps why the RBI governor has indicated at the need to target financial stability rather than prices. Both need not be mutually independent and, therefore, disregarding the inflation targeting regime altogether would not be a good decision. But there must be a recognition that the CPI basket gives food a significant weight and, therefore, perhaps, we should have a detailed discussion on targeting non-food CPI going forward. This makes sense as food inflation is unlikely to be affected by increasing interest rates. Another area which should be focussed on is forecasting which is essential as these forecasts serve as key inputs at the time of taking decisions. Over the years, we’ve witnessed significant issues with their forecasts such as in 2017 when they over-estimated inflation and in 2018-19 when they over-estimated growth.

Addressing the issues related to improving our capacity for forecasts should also be an issue that must be considered even if seems to be outside the purview of the monetary policy framework. With an internal review underway, there is hope that the process will help address some of these issues and further build the capacity of the institution responsible for playing a proactive role in India’s growth story. INAV

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