Insights into Editorial: Inflation targeting: A long way to go

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Insights into Editorial: Inflation targeting: A long way to go

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29 June 2016

With the government amending the Reserve Bank of India Act, 1934 through the Finance Bill, 2016, inflation targeting has become the primary objective of RBI. According to the monetary policy framework, agreed by RBI and the government last year, the central bank will look to contain inflation within a band of 4% plus/minus 2 percentage points from next year.

However, this is not sufficient. Several reforms will be needed to build institutional capabilities that will add up to a working IT system. These involve:

  • Changes in the working of the central bank, including, releasing better and more frequent macroeconomic data, analysis and inflation forecasts in a timely manner.
  • Changes in constituting the monetary policy committee and putting in place an operating procedure.
  • Changes in letting the currency float and liberalizing the capital account.
  • Changes in monetary policy transmission, through financial market reforms.

A central feature of a well-functioning monetary policy is monetary policy transmission (MPT). Changes in policy repo rate affect the economy through the following channels of transmission:

  1. Change in bank rates.
  2. Changes in bond market.
  3. Changes in exchange rate.

Indian scenario:

Monetary policy transmission (MPT) in India is ineffective. It is because none of the above mentioned channels works in India.

  • India is a bank-dominated economy. But, the number of banks has not increased noticeably over time. Also, the sector is dominated by public sector banks which account for 80% of the deposits but lack competitive energy. Private and foreign banks face a plethora of entry barriers. Payment banks and small banks would not make much difference here. Hence, in the absence of competition PSBs do not fell its necessary to pass on the rate changes to the final consumers. This renders the bank lending channel of transmission ineffective.
  • Unlike in advanced countries such as the US, where the bond market is an important transmission channel through which changes in monetary policy affect the yield curve, bond market development in India has been an important failure of financial sector reforms. In the absence of a large and liquid bond market, the burden of MPT falls squarely on the banks.
  • Also, in India, there exist several restrictions on the movement of capital flows. Compared to other emerging economies, India still enjoys a limited degree of integration with international financial markets. So, any change in RBI’s policy rate does not necessarily result in concomitant changes in capital flows. Besides, in India, any movement in the currency is actively managed by RBI through market interventions. These reduce the effectiveness of the exchange rate channel of transmission. In the absence of an open capital account and flexible exchange rate, this channel of MPT is rendered ineffective.

How can we ensure effective Monetary Policy Transmission (MPT)?

  • By adopting structural reforms to declog the channels of transmission. This entails improving financial inclusion, fostering a competitive environment for banks, improving the functioning of the bond market, liberalizing the capital account and letting the currency float.
  • By administering big changes in the policy rate.
  • By delivering only small changes in the policy rate. This is least painful and perhaps easiest to implement in the short run, but does not create any real impact on the economy.

Conclusion:

The government has done its bit by amending the RBI Act to incorporate IT as an objective. RBI now needs to undertake a series of actions in order to actually become an inflation-targeting central bank.