Insights into Editorial: Inflation targeting and credibility

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Insights into Editorial: Inflation targeting and credibility

13 July 2016

The government, through Finance Bill 2016, amended the RBI Act. The act clipped the central bank governor’s powers to set monetary policy.

  • The amendment removed the governor’s powers to singularly set monetary policy vesting them in a six-member Monetary Policy Committee. The process of setting up of the Monetary Policy Committee (MPC) was also recently set in motion.

Problems with the recent amendment:

The recent amendment to the RBI Act has not considered the original monetary agreement somewhat. Earlier agreement noted that the consumer price index (CPI) inflation target for financial year 2016-17 and all subsequent years shall be 4% with a +/-2% band. However, the recent amendment to the Act, which will supersede the agreement signed early last year, notes that the inflation target will be determined once every five years. The amendment doesn’t mention the inflation target range.

Why it is necessary to have inflation target range?

  • Abandoning this reform will be hugely embarrassing for the government after it agreed to it just early last year.
  • Earlier proposed target inflation range of 2-6%—outside of which the central bank will have to write to the government for the reasons for missing the inflation target and also suggest time-bound remedial actions—is already too wide.
  • The absence of the inflation target range and a categorical signal that the inflation target will be only for five years suggest that the discipline of an inflation-targeting framework isn’t fully appreciated by the government.
  • Also, according to few experts, current inflation target range of 2-6% is the widest among the main Asian inflation targeters. For example: Indonesia (3-5%), the Philippines (2-4%), Thailand (1-4%) and South Korea 2%.

Problems associated with this move:

This could offer room for some future government to live with higher inflation in anticipation of slightly better near-term growth, especially if it is worried about its political longevity. Politicians’ economic myopia will win, but the nation will lose if that approach leads to a boom-bust cycle.

How it will affect the role of MPC:

Absence of inflation target range is also expected to affect the objectivity of the government-appointed MPC members- revision in the current inflation target and /or its range.

Composition of the MPC:

The committee will have six members. Of the six members, the government will nominate three. The RBI Governor will chair the committee. The governor, however, will not enjoy a veto power to overrule the other panel members, but will have a casting vote in case of a tie. No government official will be nominated to the MPC.

  • The other three members would be from the RBI with the governor being the ex-officio chairperson. Deputy governor of RBI in charge of the monetary policy will be a member, as also an executive director of the central bank. Decisions will be taken by majority vote with each member having a vote.
  • The government nominees to the MPC will be selected by a Search-cum-Selection Committee under Cabinet Secretary with RBI Governor and Economic Affairs Secretary and three experts in the field of economics or banking or finance or monetary policy as its members.
  • Members of the MPC will be appointed for a period of four years and shall not be eligible for reappointment.

Way ahead:

Instead of further compromising the credibility of the monetary framework to facilitate lower interest rates, the government should step up its supply-side efforts to deliver low and stable inflation. This has the potential to offer a win-win combination of lower trend inflation and higher sustained economic growth.

  • The way to a significant and lasting downshift in interest rates, which in turn will boost growth, is a sustained decline in inflation, not forcing voters to live with higher-than-promised inflation. The 4% inflation target for early 2018 is ambitious but doable.

Conclusion:

The government’s institutional and supply-side reforms to achieve the inflation target so far have been disappointing. Revising the inflation target upwards to make up for that deficiency isn’t the right solution. In fact, such a revision would be the frankest admission of failure by the very government that agreed to it early last year.