How RBI’s Monetary Policy Committee has been thinking

The minutes of the past three MPC meetings offer important clues on how it has been interpreting the inflation-targeting mandate given to it by the govt


Reserve Bank of India governor Urjit Patel. The official inflation target notified by the government is 4%, with a band of 2% on either side. A lot depends on how the Monetary Policy Committee interprets this target. Photo: Abhijit Bhatlekar/Mint
Reserve Bank of India governor Urjit Patel. The official inflation target notified by the government is 4%, with a band of 2% on either side. A lot depends on how the Monetary Policy Committee interprets this target. Photo: Abhijit Bhatlekar/Mint

The monetary policy committee (MPC) will meet in the first week of April to discuss what the Reserve Bank of India (RBI) should do next. A lot of attention in the next few days will quite naturally be focused on what it will decide or what it should decide as far as interest rates go. This will be the fourth meeting of the MPC. The minutes of the three MPC meetings over the past six months offer some important clues on an issue that needs more clarity—how the committee has been interpreting the inflation-targeting mandate given to it by the government.

What is the inflation target?

The official inflation target notified by the government is 4%, with a band of 2% on either side. A lot depends on how the MPC interprets this target. There were concerns after the surprise 25 basis points rate cut in October 2016 that the committee was in effect considering the upper end of the band as the inflation target, thus raising fears about a compromise in the long fight against high inflation.

But RBI governor Urjit Patel has subsequently made clear in the December 2016 and February 2017 MPC meetings that the primary objective of the Indian central bank should be to secure the central point of the notified inflation target, i.e. 4%.

Does the real economy matter?

The minutes of the first three MPC meetings show that developments in the real economy are a central concern for monetary policy decisions. This is evident from the number of times the output gap has been mentioned in the MPC meetings. Few seem to appreciate that RBI has embraced flexible inflation targeting. It is quite different from pure inflation targeting where the central bank is solely concerned about inflation while the government is solely concerned about growth.

The importance of the output gap is implicitly recognized in the theoretical model that provides the theoretical framework of the Urjit Patel committee report. The real economy enters the model in terms of the Taylor Rule as well as the New Keynesian Phillips Curve.

However, one current problem is that RBI has not clearly indicated what it believes to be the potential rate of economic growth in India right now, so it is difficult for outsiders to assess how large the output gap is. The Indian central bank needs to share more information about its assessment of potential output.

One additional point: The discussions on the impact of demonetisation, especially in the December meeting, show that the MPC will look past temporary shocks to output or inflation rather than respond in a knee-jerk fashion—and that is how it should be.

Is there an intermediate target for Indian monetary policy?

The RBI has traditionally used money supply growth, the nominal exchange rate and the interest rate as intermediate targets to control inflation. It has now moved to directly targeting inflation, but that does not mean that the central bank has completely abandoned intermediate targets. As Michael Patra made clear in the October MPC meeting, the inflation forecast now serves as the intermediate target of monetary policy. Many central banks that have embraced flexible inflation targeting use the inflation forecast as the intermediate target. So RBI is on good ground here: it seems committed to the notified inflation target in the long run and the inflation forecast in the medium term.

However, the main problem here is that the Indian central bank does not provide enough information about its inflation forecast over the medium term in the fan charts that are released with every monetary policy statement.

What about the exchange rate?

Indian monetary policy has till now kept a close eye on the exchange rate as well. There are good reasons for central banks in emerging markets to do so—because of the impact of exchange rate shocks on inflation on the one hand and on private sector balance sheets on the other. Some versions of the Taylor Rule define the central bank response function not only in terms of the inflation gap and output gap, but also exchange rate dynamics (which in the Indian case could be the real exchange rate).

The MPC has not given too much importance to the exchange rate in its first three meetings. It is not clear whether this is because the rupee has been stable in the past six months or because the MPC members do not give weightage to the exchange rate while setting interest rates.

The MPC has also been silent on financial stability issues. One reason could be that the current monetary policy orthodoxy is that macro prudential regulations rather than monetary policy tools are a better way to achieve financial stability.

These are early days yet. The new MPC arrangement is barely six months old. There have been only three meetings till now. But the discussions during these meetings—as revealed in the minutes that have been made public—do offer some important clues on how inflation targeting is getting operationalized in India.

Finally, the unanimity in the MPC is still puzzling given the fact that a committee is supposed to be less prone to groupthink. This will undoubtedly change as the committee settles down.

Niranjan Rajadhyaksha is executive editor of Mint.

Comments are welcome at cafeeconomics@livemint.com.

Read Niranjan Rajadhyaksha’s previous Mint columns at www.livemint.com/cafeeconomics

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