Inflation Targeting & Limits of Monetary Policy Framework

27 Sep 2022 Inflation Targeting & Limits of Monetary Policy Framework

Source: The Indian Express

News: In the current inflation scenario RBI is struggling to fulfill its mandate under Monetary Policy. 

Reasons for failure of RBI to adhere to its inflation-targeting mandate in Modi 2.0

• Higher inflation in food and beverage items that have combined weight of 45.86% in the overall CPI.
• Resurgence of inflation in the last two years, driven mainly by supply-side factors such as pandemic, Ukraine war and extreme weather events like excess rain, heat wave and the deficient monsoon in the Gangetic plain in 2021-2022.
• Ineffectiveness of RBI’s demand-side toolkit to fight inflation due to high fuel and food prices .

Monetary Policy:

• Primary objective of MPC: Maintaining price stability for sustainable growth.
• The RBI Act was amended in May 2016 allowing the central bank to operate the country’s monetary policy framework. According to the RBI website MPC framework, “aims at setting the policy (repo) rate based on an assessment of the current and evolving macroeconomic situation; and modulation of liquidity conditions to anchor money market rates at or around the repo rate “Repo rate changes transmit through the money market to the entire the financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth.”

Monetary Policy Committee constituted under section 45ZB of the amended RBI Act,1934:

• Central government will constitute a six-member Monetary Policy Committee (MPC).
• MPC will determine the policy interest rate required to achieve the inflation target.
• First MPC under the amended RBI Act was constituted on September 29, 2016.
• Monetary Policy Committee’s decision shall be binding on the Bank.
• The RBI Act, 1934 was amended, and the policymakers adopted the notion of central bank “independence with accountability.”
• Central government, in consultation with the Reserve Bank of India (RBI),will set an inflation target based on the consumer price index (CPI) once every five years. 
• RBI was independent to conduct its monetary policy in the way it wants, but it will be held accountable if it fails to meet inflation targets.
• Through the monetary policy framework the central bank will freely set up interest rates to achieve low and stable inflation without government interference or electoral pressure.
• Under section 45ZA of the RBI Act,1934,the center in consultation with RBI has fixed the CPI inflation target at 4% with an “upper tolerance limit” of 6%.
• In case RBI fails to achieve its inflation target for any three consecutive quarters it has to submit a report to the center stating reasons for its failure to achieve the inflation target and possible remedial measures to be taken by the bank.

Members of MPC:

• RBI Governor as ex officio chairperson of MPC.
• Deputy Governor in charge of monetary policy. 
• An officer of the Bank to be nominated by the Central Board.
• Three “persons of ability, integrity and standing, having knowledge and experience in the field of economics or banking or finance or monetary policy” to be appointed by the central government.

Limits of monetary policy framework:

• Overshooting of the inflation target leading to failure of accountability: In 2022, from January to August actual year-on-year inflation has ruled above 6% every single month well beyond CPI inflation target of RBI. If RBI fails to meet the upper tolerance level of the inflation target “for any three consecutive quarters” it has to submit a report to the central government.
• Monetary dependence, not independence: In developed countries the share of food items in the consumption basket is hardly 10-25%, hence inflation can be controlled through repo interest rate or cash reserve ratio or by raising borrowing costs for firms and consumers. But, the weight of food items in the Indian consumption basket is 45.86% forcing RBI to rely more on government action to meet inflation targets. So, the RBI has to depend on “supply-side” measures by the government to curb inflation.

Article: Explained Economy: Limits of free monetary policy; Everyday Economics: What is the RBI’s MPC, and what does it do?

Article Link:

1.https://indianexpress.com/article/explained/explained-economics/limits-of-free-monetary-policy-8172734/;

2.https://indianexpress.com/article/explained/everyday-explainers/what-is-rbi-mpc-and-what-does-it-do-7801244/

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