There is a compelling case for another reduction of 25 basis points in policy interest rates when the Monetary Policy Committee (MPC) makes its next decision in the first week of August. Consumer prices have gone up at an average annual rate of 3% in the 12 months to June, a percentage point below the central point of the inflation target. The Reserve Bank of India (RBI) has not only cut interest rates by 75 basis points this year, but has also kept the money market in surplus liquidity mode to help policy transmission.

Meanwhile, economic growth in the fourth quarter of the previous financial year was at its lowest in five years—and 2.2 percentage points lower than the growth rate in the first quarter. There are no immediate signs of a sharp recovery in economic momentum. The recent decline in core inflation is also an indicator of weakening domestic demand. Inflation is sequentially going up, but does not seem to be a major risk right now.

A lot now depends on how the MPC interprets its inflation mandate. A bit of recent history could be useful in this context. The MPC had cut interest rates by 25 basis points in its first meeting held in October 2016. Not everybody expected the

committee to reduce rates given the inflation pressures at the time.

There was some confusion in financial markets about how the MPC would interpret the inflation mandate given to it by the government. The unexpected rate cut suggested that the MPC would use the 6% upper bound of its inflation target as the effective target. That would have meant a completely different approach to interest rate policy.

Governor Urjit Patel cleared the air in the minutes of the December 2016 policy meeting. “It is important for monetary policy to stay focused on the medium-term and strive to achieve, on a durable basis, the middle of the notified inflation target range, i.e. 4 percent," he said. This was perhaps the first signal that the MPC would try to keep headline consumer price inflation close to 4%, with the two-percentage-point band on either side providing it flexibility in case there were sudden movements in volatile food and energy prices.

This was indeed the correct definition of the inflation mandate given to the central bank by the Indian government through the monetary policy agreement signed in February 2015. It said that the inflation target for 2016-17 and all subsequent years shall be 4%, with a band of +/- 2%. Most MPC policy statements after December 2016 mention 4% as the inflation target.

The 4% target recommended by the Urjit Patel committee can be understood in three different ways. As I explained in a recent working paper for IDFC Institute, the committee used an econometric model to estimate the threshold level of retail inflation in India at 6.2% (Reserve Bank of India 2014). Economic growth gets hurt whenever consumer price inflation crosses this threshold. So, 6% became the upper bound of the policy target for RBI. In an open economy, the domestic inflation rate also has to be sensitive to the global inflation rate. The latter—at 2%—provided the lower bound of the target inflation range. The 4% mid-point of the range thus became the inflation target for monetary policy.

Also, the desired Indian inflation rate is 2 percentage points above the global inflation rate because of faster productivity growth in an emerging market such as India. The Patel committee argued that the output gap was at zero between the third quarter of 2003-04 to the first quarter of 2006-07, when average retail inflation was 4%. The sensitivity of Indian retail inflation (and inflation expectations) to food price shocks—thanks to the high weight of volatile food prices in the consumer price index—also provided an argument for having an inflation band rather than a point estimate for the central bank to target.

A senior finance ministry official has recently reiterated in an interview to this newspaper that the threshold inflation in India is 6% rather than 4%. That is very much in tune with what the Patel Committee said in its report. Output growth gets hurt only when inflation crosses 6%. However, there could be fresh concerns—perhaps unwarranted—whether this is an advance indication that the effective inflation target will be the upper bound rather than the mid-point of the range, bringing back echoes of October 2016.

The fears seem unfounded. RBI Governor Shaktikanta Das has also signalled that the inflation mandate will continue to be interpreted as before. For example, the minutes of the February meeting quote Das as saying: “The headline inflation one-year ahead is projected to remain below the target level of 4%." The real debate that should begin soon is whether the current inflation mandate should continue after 2021 or whether there is a case for a fresh look.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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