Monetary Policy Committee and Inflation Targeting

Reserve Bank of India (RBI) as the custodian of monetary policy in India was established upon recommendations of Hilton Young Commission as per provisions of RBI Act 1934. It started it’s operations on 1st April, 1935 with headquarters in Kolkata which was later shifted to Mumbai in 1937.

The RBI Governor is appointed by Prime Minister of India in consultation with Union Finance Minister. Since RBI Governor is appointed by the Prime Minister, this accords his position a political tinge and he may be forced to tow the directives of his political boss while setting the tone of monetary policy.

Before we go on to study the implications of political post (RBI Governor) on monetary policy, we need to understand the essence of monetary policy. Monetary policy is a regulatory tool used by RBI to govern the supply of money (liquidity) in the economy so as to keep inflation within acceptable limits. When there is excess money in the economy in relation to the availability of goods and service suppliers, the prices rise. When this price rise is substantial and sustained, it is termed as inflation. Inflation is always measured in terms of inflation rate and expressed in percentage (%).

What causes inflation? Is inflation good for the economy and if yes, then what is the expected level of inflation that is agreeable to the economy!

The primary cause of inflation is the mismatch between demand and supply. The mismatch can be in following context:

1. Excess money supply that raises aggregate demand: For instance, when individual’s income increases, he likes to consume more of a commodity. This excess demand because of rise in income disturbs the market equilibrium between demand and supply. In order to check the excess supply of money, RBI raises interest rates which act as incentive for abstaining from present consumption.

2. Supply deficiency: A shortfall in the production of a commodity fails to meet even the basic needs of the citizens and thus prices rise causing inflation.

A moderate level of inflation is good for the economy which may vary from country to country. In India, the expected inflation rate is roughly 4% to 5%. This means that a commodity that costs Rs100 this year shall cost Rs104 the next year. Employees expect their employers to keep this moderate level of inflation in mind while raising the salary levels so as to give a salary hike in real terms.

Nation’s GDP is measured in ‘constant currency’ terms at ‘Factor costs’ so as to measure economic growth in real (volume) terms. If GDP were to be measured at market prices, then high inflation would misrepresent the economic growth indicator.

A moderate level of inflation refers to the inflation rate that is acceptable to the economy. A moderate level of inflation is good for the economy as it signals growing aggregate demand by rising population. This rise in aggregate demand acts as an incentive for business houses to expand production base thereby generating jobs. In India, moderate/acceptable inflation band has been defined as 2% to 6% by the newly constituted Monetary Policy Committee.                                                                 

Monetary Policy Committee (MPC)

The signal interest rate in India is Repo Rate which is used by RBI to control the supply of liquidity in the economy. Until August 2016, RBI Governor had the final say in setting the tone of monetary policy that governed the Repo Rate. However, it is being debated that can a single person be made responsible for setting the pace of economic growth rate in the country as repo rate determines the ease of credit availability which in turn governs the pace of economic activity. In light of the international practices as in Britain, it was decided to constitute a Monetary Policy Committee that would set the tone of monetary policy in a democratic and transparent manner. This committee would consist of six members comprising three members from RBI and three members appointed by Centre on recommendations of search-cum-selection committee headed by Cabinet Secretary of India.

MPC Members:

RBI Members of MPC:
• Governor as the ex-officio chairperson
• Deputy Governor
• One officer of Central Bank (RBI)

Members appointed by Cabinet Secretary headed committee: would be experts in the field of economics or banking or finance or monetary policy and will be appointed for a period of four years and shall not be eligible for re-appointment.

MPC would meet four times a year and make public its decisions following each meeting.

Democratic decision making: The tone of the monetary policy would be determined by consensus amongst its six members. In case of tie, Governor would have the casting vote.

Inflation Targeting

Inflation Targeting refers to keeping inflation rate within the permissible band so that business houses can plan their investment activities.

In order to invest in business activities, credit should be made available at cheap rate. If cost of credit is high then loans would be expensive. Firm would find it difficult to repay the expensive loan given the prevailing market conditions and thus postpone its capital expenditure plans. This in turn would mean loss of economic growth and potential employment opportunities.

Therefore, it is imperative that business houses are provided with a stable inflation regime that allows them to plan their activities in advance and contribute to nation’s GDP. Secondly, foreign investments would flow into India only when the macro-economic position of the country is stable. It is in this context that MPC has been given the task to ensure a moderate inflation rate that spurs economic growth and ensures price stability (moderate inflation).

By: Abhinav