The evolving monetary policy committee culture
The six economists who decide Indian monetary policy are due to meet again in the first week of August. Most of the commentary will be focused on whether interest rates need to be cut. Consumer price inflation in June was below the official target range, though it is worthwhile to remember that the monetary policy agreement explicitly says the Reserve Bank of India (RBI) will have failed to meet its policy goal only if inflation is outside the agreed range for three quarters in a row, and not for any one single month.
This instalment of Cafe Economics deals with another issue altogether. The past year has seen the monetary policy committee (MPC) gradually settle into its job. It has not buckled under pressure to cut interest rates. The MPC members refused to attend a meeting called by the finance ministry just before the June monetary policy decision. The tiresome consensus has been replaced by dissent when Ravindra Dholakia voted for a rate cut while the other five members of the committee voted to hold rates. An independent MPC culture seems to be evolving. It should be welcomed.
What next? Here are a few suggestions.
First, the inflation-targeting framework needs to be explained better to the outside world. Too much of the public debate is focused on the latest inflation number rather than what lies ahead. Indian monetary policy operates with a lag of around three quarters, so the MPC has to take a decision today based on its assessment of where inflation will be around nine months down the line, and not where it was a month ago. In other words, the intermediate target of Indian monetary policy under the new regime is the inflation forecast rather than past inflation.
That is not all. The role of other factors such as the output gap or core inflation—which feature prominently in the minutes of the MPC meetings—also need to be explained better. The RBI should come out with a working paper to communicate what the MPC is trying to do under the inflation-targeting framework. There is still too much ignorance about this, at least going by the public debate.
Second, the inflation forecasts themselves have been a problem. The Indian central bank slashed its inflation projections in June, a sign that it had overestimated price pressures earlier in the year. This is in contrast to much of the past decade, when both the central bank and the finance ministry have underestimated inflation pressures.
Inflation forecasting is not an easy task, especially given large exogenous shocks such as demonetization or the introduction of the goods and services tax. The issue is not just the statistical models being used to predict inflation trends. Much of the volatility of Indian inflation can be explained by shifts in food prices. The standard cobweb model in microeconomics tells us that food prices are volatile because farmers tend to take decisions on historical rather than future prices. Their expectations are adaptive. For example, there is a tight correlation between the production of pulses and their lagged prices. The Indian central bank needs more people with expertise in agricultural economics to help with its analysis of inflation.
Another tricky issue for monetary policy is a better understanding of the Indian business cycle, a challenge that MPC member Chetan Ghate has recently dealt with in an excellent presentation (goo.gl/jSJtcu).
Third, modern monetary policy depends heavily on variables that cannot be directly observed—potential growth rate, the output gap, inflation expectations and the equilibrium rate of interest, for example. There is still not enough clarity on how each MPC member views the current economic condition in terms of these economic variables. The US Federal Open Market Committee publishes its famous dot plots to show the inflation expectations of each member.
The Indian MPC need not necessarily go down that path, but needs to share more information on the empirical basis of the decision of each member. The outside members in particular should not be dependent only on the official RBI forecasts or those of international agencies such as the Economic Cycles Research Institute. Some central banks even share their general equilibrium models with the outside world.
Fourth, the internal dynamics of the MPC will be worth watching now that the first dissent vote has been cast. There are two issues for the next few meetings. Will the internal members from the RBI habitually vote as a block or will their votes also be divided in the months ahead? And how will governor Urjit Patel use his extra casting vote in case there is no clear majority decision in the MPC?
It is also interesting that the governor seems to speak last in the MPC meetings, at least going by the way the minutes are published. That is good practice. Perhaps future scholars with access to full details of the first MPC meetings will be able to glean insights about strategic voting or agenda-setting in these meetings.
It will naturally take time for the MPC culture to fully bloom. The initial signs have been good. The first examples of independence are welcome. So is the dissent vote in June. The challenges ahead are in communications, empirical research and voting patterns—all of which need to be nurtured by the governor as the first among equals in the MPC.
Niranjan Rajadhyaksha is executive editor of Mint.
Comments are welcome at firstname.lastname@example.org. Read Niranjan’s previous Mint columns at www.livemint.com/cafeeconomics
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