Monetary Policy news for UPSC/IAS examination
Monetary policy is an important tool to control the money supply and inflation in the economy. The policy has a direct impact on the consumer and is one of the most important aspects to keep the economy on track.
Monetary policy section of the economy would provide all the news related to inflation, changes in monetary policies and various CPI and WPI indexes, which are relevant for UPSC examination.
Updates on issues and concepts related to Monetary policies in India for 2020/21:
Alternatives to Inflation Targeting
Synopsis: Many economists are criticizing the RBI’s role in inflation targeting. They are suggesting alternatives to inflation targeting. Let’s have a look at them.
- The central government confirmed the continuance of inflation targeting as a tool to monitor inflation within the same bandwidth.
- The “inflation targeting” regime came into force in 2016. Recently inflation targeting has been renewed for another five years.
- Following this, the RBI will continue to target maintaining retail inflation within the band of 2% to 6%.
- RBI will use the headline inflation to control the inflation as it reflects the prices of essential consumer goods.
- Retail core inflation, is the inflation rate without taking into account the fluctuations in the prices of fuel and food items.
Why many people have criticised RBI’s role in inflation targeting?
Many have criticised the RBI’s mandate of inflation targeting because of its contradictory role.
- RBI acts as a regulator to maintain financial stability and control prices in the economy by increasing interest rates. But this has a negative consequence on economic growth.
- Also, RBI is responsible to boost the economy by reducing repo rates. Because Cheaper loans will make it easier for firms and governments to borrow and spend/invest thus leading to economic growth.
- Between 2016 and 2020, many times RBI focused more on keeping retail inflation low by setting high interest. This has affected India’s economic growth.
Alternative suggestions to inflation targeting:
- First, instead of headline retail inflation, the RBI should focus on the retail core inflation rate. Because fuel and food prices often shoot up in the short-term due to supply disruption.
- Second, RBI should not be looking at retail inflation. Instead, it should look at wholesale inflation. Because RBI’s move to tweak interest rate affects the credit available to businesses. This, in turn, is affected by wholesale inflation, and not retail inflation.
- Third, RBI should neither use the wholesale nor retail inflation rate as targets. Instead, the RBI should create a Producer Price Index to suit the RBI’s need.
- Fourth, a singular focus on maintaining price stability will be counter-productive for a developing economy such as India. They argue that the RBI should be working with the government towards ensuring fast economic growth rather than focusing on inflation targeting. Their argument is that inflation targeting is not the only way to be prudent about macro-financial stability.
Why RBI should continue Inflation targeting?
There are many benefits associated with Inflation Targeting. They are,
- First, a high inflation rate is the most regressive kind of tax. The poorest people suffer the most. By targeting inflation India can avoid hurting poor people.
- Second, as NPA’s or bad loans are being recognised by banks, macro-financial stability will come into sharp focus. Inflation targeting can provide such macro-financial stability.
- Third, Inflation targeting also takes care of supply-side bottlenecks. For example, India’s inflation rate remains somewhat constant despite the increasing fuel prices and Covid-induced lockdowns in India.
But, Under the given circumstances, it is a wise decision by the government to allow RBI to focus on targeting retail inflation. This will ensure that India’s poorest, who are the most hit by the pandemic will not be affected further.
Source: Indian Express
Need of Continuing with Inflation Targeting
Synopsis: Inflation is still a big worry for policymakers. That is why the government is still willing to retain the inflation targeting.
The Finance Ministry will continue with the inflation-targeting framework. It will guide the interest rate decisions of the RBI’s Monetary Policy Committee over the five-year period.
- The Department of Economic Affairs notified that the inflation target for the next five years ending on March 31, 2026, will be 4%. The upper tolerance level will be 6% and a lower tolerance level will be 2%.
- It means no change has been introduced to the framework.
How will the announcement by the department of economic affairs be perceived?
The announcement indicates that price stability will be the base for all macro-economic development.
- Firstly, the announcement is a relief as inflation pressure is rising. The recent Consumer Price Index data show retail inflation increased by almost 100 basis points in February. Food and fuel costs remain volatile till now.
- As per IHS Markit India Business Outlook survey companies are planning to raise selling prices in the coming 12 months to cope with rising costs of raw materials.
- Secondly, the RBI’s officials have emphasised on the need to preserve the flexible inflation targeting framework. In a paper titled ‘Measuring Trend Inflation in India’, Deputy Governor Michael Debabrata Patra, and a colleague highlighted the importance of guaranteeing the inflation target.
- Thirdly, there has been a steady decline in trend inflation to a 4.1%-4.3% band since 2014. The officials said that a target lower than the trend had the risk of imparting a deflationary bias. This bias would reduce economic momentum.
- A goal much above the trend could cause expansionary monetary conditions that would likely lead to inflation shocks.
The RBI’s researchers Report on Currency made it clear that the framework had served the economy well. The government’s economic officials have noticed that it will certainly reassure investors and savers that inflation remains a central concern for all policymakers.
Source: click here
Center to Retain the “Inflation Targeting” at 4% for MPC
What is the news?
As per the top finance ministry official, the center will retain the Inflation Targeting of 4% for MPC.
- The Centre will retain the inflation target of 4%, with a tolerance band of +/- 2 percentage points.
- This target will be applicable for the period April 1, 2021, to March 31, 2026.
- Recent high inflation together with low economic growth ignited the debate on the relevance of Inflation targetting.
- However, as per 14th Finance Commission member M. Govinda Rao, the range of 2%-6% as a flexible inflation target has worked reasonably well.
Inflation targeting refers to keeping the inflation rate within the permissible band to ensure the certainty for carrying out investment activities.
The agreement between the Reserve Bank of India (RBI) and the central government signed in February 2015. The agreement explicitly made inflation targeting the objective of the MPC while using the repo rate as the instrument for it.
The Reserve Bank’s MPC was given the target of keeping inflation at 4% with a tolerance limit of 2%. This meant that inflation should be between 2% and 6%.
About MPC (Monetary Policy Committee)
- The Monetary Policy Committee (MPC) is a committee of the Central Bank of India (Reserve Bank of India). The RBI Governor heads it.
- The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016.
- It provided for a statutory and institutionalized framework for a Monetary Policy Committee. MPC maintains price stability while keeping in mind the objective of growth.
- The function of MPC is to fix the benchmark policy interest rate (repo rate) to contain inflation within the specified target level i.e. inflation targeting.
Source: The Hindu
Impact of inflation targeting in India
Synopsis: According to the Executive Director IMF, Surjit S Bhalla, Inflation targeting has been ineffective in controlling inflation. Moreover, it has also contributed to a decline in GDP growth because of high repo rates.
About inflation targeting
- The concept of ‘Inflation targeting’ was got acceptance in New Zealand first. Later, 33 countries adopted it as well.
- India formally adopted it in 2016, at the first meeting of the RBI Monetary Policy Committee (MPC).
- The MPC considered a real repo rate of 1.25 percent as the neutral real policy rate for the Indian economy.
- A neutral policy rate means the policy rate will be consistent with the growth potential of India.
- The primary goal of inflation targeting is to contain inflation at around 4 percent, within the allowable range of 2 to 6 percent.
What are the impacts of inflation targeting in India?
The author, in his research paper, has evaluated the inflation target in a global context. It made the following conclusion based on the last 40 years for both the inflation targeting economies and the non-targeting economies.
- First, countries that did not adopt inflation targeting were able to control inflation better than the countries that used inflation. For example, India’s inflation was around 5.2% (2015-19) for the same period it was 2.4% for economies that did not adopt inflation rate targeting.
- Second, inflation depends on global variables, and it is not dependent upon one single factor. So, using an inflation targeting mechanism will not effectively control inflation. For example, 2000-04, has been the golden period of inflation all over the world even in India. During this time, inflation rate targeting was not in place in India, yet inflation was very low.
- Third, the belief that a high Fiscal deficit will contribute to high inflation is not true. For example, FRMB act was in place after 2003. However, Inflation in India increased from 3.9% (2000-04) to 7.1% (2005-09) despite the fiscal deficit were limited as per the FRBM act.
- Fourth, inflation targeting has negatively impacted GDP growth. High policy rates (repo) maintained to control inflation affected the cost of domestic capital. It led to a decline in investment rate thereby resulted in less GDP. For example,since2016, (after inflation rate targeting was institutionalised), there has been a steady increase in repo rates, and a steady decline in GDP growth
Source: Indian Express
Relevance of Inflation Targeting in India
Synopsis: Inflation control will always be relevant. But there is no conclusive evidence that the policy of inflation targeting has worked in India.
- The RBI was tasked with a mandate of the inflation target of 4 percent with a 2% deviation either way in June 2016. This agreement between the centre and the RBI is set to end by march-31-2020.
- It has been acknowledged that in these 5 years period (2016-2021) after inflation targeting was introduced,
- Inflation rate has remained within the prescribed band of 2% to 6%.
- Also, the RBI has been successful in anchoring inflationary expectations.
- Against this backdrop, this article evaluates the success of inflation targeting as an effective monetary policy in India.
What is inflationary targeting?
- Inflation targeting prescribes the use of the interest rate to target inflation. Whereas other methods to control inflation targets money-supply (monetarist approach). For example, Open Market operations.
- Some suggest inflationary targeting is more effective than the monetarist approach, as the policy interest rate, is under the direct control of the central bank.
What are the issues in Inflation targeting?
First, inflation targeting is not statistically validated for Indian data.
- The model of Inflation targeting is based on the assumption that inflation means overheating the economy. i.e., increased output greater than natural level output.
- So, the Central bank will recommend raising the rate of interest (repo rate). This will eventually reduce the money supply in the economy and normalize economic activity, thereby achieving a reduction in inflation levels.
- However, it is impossible to observe the level of output in an economy. Hence, setting policy rates based on the assumption that the economy has overheated is unscientific.
Second, the belief that RBI can successfully control inflation using Inflation targeting is not completely true. Consider the following examples,
- First, RBI data on household expectations showed that inflation will remain well above 6% up to 2020.
- However, inflation had fallen steadily since 2011-12, halving by 2015-16. During this period inflation targeting was not introduced. So, this explains that there are other factors that control inflation.
- Second, during lockdown food inflation peaked even when the inflationary targeting mechanism was in force. It was mainly due to supply chain disruption during the lockdown.
- Also, the lockdown period witnessed a contraction in growth but coincided with inflation. This is against the core principle of inflation targeting that inflation denotes overheating economy.
- Third, if the inflation in India has been controlled via inflation targeting in the past five years, it would have benefitted growth, exports, non-performing assets (NPAs) of commercial banks, and employment.
- However, the result has not been on the expected lines. Only, private investment has declined as higher interest rates contributed to a declining private investment rate.
- Other factors employment and exports are declining steadily.
- Also, NPA’s are increasing since 2016. The cases of IL&FS, PMC Bank, PNB and YES Bank suggest that poor management and maladministration in the financial sector can escape RBI scrutiny as they tend to focus more on inflation targeting.
Source: The Hindu
Factors affecting present inflation level in India
Synopsis: The recent January 2021 retail inflation data provides relief to monetary authorities. Consumer Price Index (CPI) stood at 4.06% which is a desired outcome for ensuring macroeconomic stability.
- The inflation had remained above the RBI’s threshold mark of 6% for six months till November. The ideal range of CPI is 2-6%.
- In January 2021, inflation reached a 16-month low.
- The fall in the inflation rate was particularly attributed to a modest rise of 1.89% in Consumer Food Price Index. This was majorly a result of 15.48% drop in vegetable prices and easing of cereal prices.
RBI’s view over inflation:
- As per RBI, bumper Kharif crops, good vegetable supply in winters, and better prospects of rabi produce could reduce inflation in future months.
- Further, rising fears of avian flu will decrease poultry demand and control inflation.
- However, RBI is cautious of higher inflation in pulses and edible oils. A 13.4% price rise was seen in pulses and products. Further, the rise in the oils and fats category was 19.7%.
Future concerns which may cause inflation to rise:
- First, inflation for eggs and meat was in double digits despite the avian flu threat.
- Second, the favorable base effect is about to decrease. It is causing fear of rising inflation in the future. The base effect is the fluctuation in a monthly inflation figure due to law or high base i.e. level of inflation in the same month a year-ago.
- Third, the producers in multiple sectors (automobile, real estate, etc.) are expected to transfer the cost of inputs to consumers. This is due to rising input costs as shown by IHS Markit India Manufacturing Purchasing Managers’ Index (PMI).
- Fourth, the rising fuel prices could also contribute to increasing inflation. Diesel has already crossed the 80 rupees mark which has pushed prices of numerous goods.
In the current scenario, banks are given necessary support which has enhanced their liquidity. This calls for due vigilance by policymakers, else inflation can’t be moderated thereby impacting macroeconomic stability.
Why prices of Petrol and Diesel are rising?
Synopsis: Retail prices of petrol and diesel have reached record highs in India. One major reason is a heavy tax on Petrol and diesel in India.
The price of petrol is touching Rs 89 per litre in Delhi and diesel reaching Rs 86.30 per litre in Mumbai. The government states that the reason behind this rise in price is an increase in global crude prices by more than 50 per cent.
While retail prices of both fuels in other countries are just reaching pre-pandemic levels, Indian consumers are paying a lot more.
Why are consumers in India paying more for petrol and diesel?
Retail petrol and diesel prices are linked to global crude oil prices in theory. That means if crude prices fall, retails prices should come down too, and vice versa. However, this does not happen in reality especially in India.
- First, when global prices go up, the consumer has to pay the increase in price. But when the prices decrease, the government introduces fresh taxes to ensure that it collects extra revenues.
- For instance, the government hiked the central excise duty on petrol and diesel at the beginning of 2020 to boost revenues. The government did this to boost economic activity government. This resulted in the revenue gain to the government.
- Currently, state and central taxes amount to around 180 per cent of the base price of petrol and 141 per cent of the base price of diesel in Delhi.
- Second, crude oil prices collapsed during the pandemic. But as economies have reduced travel restrictions, global demand has improved, and prices have been recovering.
- Third, the controlled production of crude amid rising demand has been another key factor in boosting oil prices.
- Fourth, Oil Marketing Companies (OMCs) are free to set prices for petrol and diesel based on international prices on paper. Increase in central levies has meant that the consumer hasn’t benefited from low international prices and has ended up bearing the cost of rising crude oil prices.
- Experts suggest that the impact of rising fuel inflation has been balanced by declining food inflation. However, the consumers with greater expenditure on travel are bearing the higher prices even though the overall inflation reduced down to 4.06 per cent in January.
RBI’s expansionary policy and challenge of the impossible trinity
Synopsis: RBI need to exit out of its expansionary policy and manage ‘the impossible trinity’, i.e. Capital inflow, inflation and exchange rate.
Source: The Hindu
- RBI adopted the extraordinary expansionary policy after Covid-19.
- It reduced policy interest rates aggressively to increase the liquidity in the market. It also provided targeted assistance to especially distressed sectors.
- But, now RBI should consider an exit plan out of expansionary policy to avoid any loss in the macroeconomic terms.
- In this process RBI might face the challenge of managing ‘the impossible trinity’, i.e. Keeping doors open for capital flows while simultaneously maintaining a stable exchange rate and restraining inflation.
What are the challenges in managing ‘the impossible trinity’?
Firstly, RBI need might face a dilemma of managing Inflation and support to economic recovery.
- Inflation is above the RBI’s target band for the past several months and is expected to remain above target for the next several months.
- Whereas, MPC is not able to decide against the expansionary monetary policy, out of concerns for growth and financial stability.
- MPC expects inflation to soften by itself due to bumper winter crop and normalisation of supply chain post-lockdown.
Second, RBI needs to think about the savers, offered low-interest rates at a time of high inflation. Thus, the value of their saving is getting reduced.
Third, RBI require to withdraw the ‘excess’ liquidity from the market.
- Banks are routinely depositing trillions of rupees with the RBI is evidence that the liquidity increase by RBI is not giving the intended results.
- Mispricing of risk of too much liquidity for too long can lead to the financial crisis.
Fourth, RBI might face the challenge of ‘taper tantrums’ at the later stage, which triggers the panic sell-off by the investors in the market.
- Taper tantrum: In May 2013, U.S. Federal Reserve Chairmen announced that they were considering gradually tapering/reducing ‘quantitative easing’.
- Although the announcement should have been taken as signs of a robust recovery in the economy, instead panic sell-off started in the financial market.
- Thus, RBI also need to frame their communication strategy in a way that it doesn’t trigger the panic sell-off.
Fifth, RBI will have to stop the rupee from appreciating, in the face of policy change.
- Current Account Surplus this year together with massive capital flows has caused increase in flow of dollar in the system.
- It is putting the upward pressure on the Rupee, which is already overvalued in the real terms.
- RBI has already absorbed this year, nearly $90 billion to prevent exchange rate appreciation and to maintain the competitiveness of the rupee.
- Thus, RBI’s ability to keep the Rupee value in control will be constrained by increasing inflation.
In the upcoming days, managing the impossible trinity will be a tricky challenge for RBI given the condition of the economy after COVID-19.
Read Also :upsc previous year question paper
India’s retail inflation
Context- Retail inflation showed signs of easing in November, led by easing prices of some food items.
More in news-
Consumer Price Index inflation stood at 6.93% in November 2020 compared to 7.61% in October, according to data released by the Ministry of Statistics and Program Implementation, though it remained above the comfort level of the Reserve Bank.
What are the reasons for decline in CPI inflation?
- The movement in retail inflation is broadly driven by the movement in food and beverage inflation which has 46 per cent weight in the consumer price index.
- Within the food items, the inflation declined for vegetables to 15.63%, cereals and products 2.32%, meat and fish 16.67% and milk and products 4.98%.
- Inflation in the key transport and communication category that includes petrol and diesel eased by a marginal 10 basis points to 11.06%.
- The inflation for housing eased to 3.19%, while that for miscellaneous items was flat at 6.94% in November 2020.
- Within the miscellaneous items, personal care and effects 11.97%, recreation and amusement 4.57%.
What are the areas of concern for RBI?
- Inflation remained above the comfort level of the RBI-
- Out of the food basket of 12 items, inflation still remained in the double digits in the case of six.
- Key protein sources including pulses, eggs and meat and fish continued to register worryingly high levels of inflation.
- Worrying high transportation cost– With oil marketing companies continuing to raise pump prices of these crucial transportation fuels, it is hard to foresee any further appreciable softening in food prices in December.
- This put the RBI’s forecast for average fiscal third-quarter inflation of 6.8% in jeopardy.
Disrupted supply chain logistics, higher operational and labour costs, higher administrative fuel costs partly contribute to the upward inflation trajectory in recent months.
What is the way forward?
- Policymakers must guard against easing vigilance on prices while considering growth-supportive measures.
- Price stability must remain the monetary authority’s primary target.
- The decline in the CPI inflation print in Nov 2020 to 6.93 per cent from 7.61 per cent in Oct 2020 has definitely come as a relief to the bond markets.
RBI allows RRBs to access LAF, MSF windows
Source: Click here
News: Reserve Bank of India(RBI) has allowed regional rural banks (RRBs) to access the liquidity adjustment facility(LAF), marginal standing facility(MSF) and call or notice money markets with the aim to facilitate better liquidity management for these lenders.
- Liquidity Adjustment Facility(LAF): It is a facility extended by the Reserve Bank of India to the banks to avail liquidity in case of requirement or park excess funds with the RBI in case of excess liquidity on an overnight basis against the collateral of Government securities including State Government securities.
- Marginal standing facility(MSF): It is a window for banks to borrow from the Reserve Bank of India in an emergency situation when interbank liquidity dries up completely.MSF rate is generally higher than Repo rate.
- Call or Notice Market: The call/notice money market forms an important segment of the Indian Money Market.Under call money market, funds are transacted on an overnight basis and under notice money market funds are transacted for a period between 2 days and 14 days.
- Regional Rural Banks: These are financial institutions which ensure adequate credit for agriculture and other rural sectors.They were set up on the basis of the recommendations of the Narasimham Working Group (1975), and after the legislation of the Regional Rural Banks Act, 1976.
- First RRB: The first Regional Rural Bank “Prathama Grameen Bank” was set up on 2nd October, 1975.
- Stakeholders: The equity of a regional rural bank is held by the Central Government, concerned State Government and the Sponsor Bank in the proportion of 50:15:35.
- PSL: The RRBs are required to provide 75% of their total credit as priority sector lending(PSL).
Highlights of MPC meeting
Context- RBI in its 6th bi-monthly MPC meeting voted unanimously to maintain status quo on benchmark interest rates to support the economy.
What were the key highlights of latest MPC meeting?
The Monetary Policy Committee (MPC) recently left benchmark interest rates unchanged and maintained an ‘accommodative’ policy stance as it prioritized support for the economy’s recovery over ‘sticky’ inflation amid the COVID-19 pandemic.
- The RBI keeping rates low despite high inflation shows its focus to boost economic growth over keeping inflation under check which is majorly a supply-side issue.
- Decision – The MPC kept the RBI’s key lending rate, the repo rate, steady at 4%.
- MPC panel projected that the real GDP contraction will contract at 7.5% [-7.5%] for the financial year ending. It is an upgrade in comparison to -9.5% in October MPC review.
- Citing the improvement in activity in the second quarter, it projected GDP would return to growth of 0.1% in Q3, and expand 0.7% in Q4.
- The RBI also announced a raft of liquidity management measures and steps to improve regulatory oversight of the financial system.
- MPC expects inflation to rise in the near term.
What are the key challenges?
- Cost push pressure– The increase in the prices of iron ore, steel and transportation fuels also add to the worries that cost pressures are continuing to accumulate.
- Food inflation surges to double in October 2020 across protein-rich items including pulses, edible oils, vegetables and spices on multiple supply shocks.
- Booming financial markets and rising asset prices because of surplus liquidity will also contribute to upside risks.
- MPC’s policy approach is clearly fraught with risks. A small window is available for proactive supply management strategies to break the inflation spiral being fuelled by supply chain disruptions, excessive margins and indirect taxes
- The RBI policy is supportive of growth and in sync with the government’s reform agenda.
RBI monetary policy Explained: Why have rates been kept unchanged yet again?
Source: Click here
News: Reserve Bank of India’s(RBI) Monetary Policy Committee(MPC) has announced its bi-monthly monetary policy review for the month of December.
- Repo Rate: It is the rate at which the RBI lends money to the banks for a short term.It remains unchanged at 4%.
- Reverse Repo Rate: It is the short term borrowing rate at which RBI borrows money from banks.It remains unchanged at 3.35%
- Marginal Standing facility: It is a window for banks to borrow from the Reserve Bank of India in an emergency situation when interbank liquidity dries up completely.It has remained unchanged at 4.25%.
- Inflation: Inflation has remained consistently above the upper end of RBI’s mandated 2-6% target range every month barring March,2020.
- Growth Projection: RBI has revised its GDP growth expectation for 2020-21 to -7.5% from -9.5% which signals improvement.
- Accommodative Stance: RBI has maintained an accommodative stance implying more rate cuts in the future if need arises to support the economy hit by the COVID-19 pandemic while ensuring inflation remains within the target.
- Tighter Norms for UCBs and NBFCs: RBI has announced the introduction of risk-based internal audit norms for large urban cooperative banks(UCBs) and non-banking financial companies (NBFCs) as part of measures aimed at improving governance and assurance functions at supervised entities.
Read Also : Government Schemes for upsc
- Monetary Policy Committee(MPC): It is a statutory committee of the Reserve Bank of India which consists of six members with three nominated by the Union government and three representing the RBI.It is mandated by law to ensure that retail inflation stays within a band of two percentage points of the target inflation rate of 4%.
RBI sets up Reserve Bank Innovation Hub(RBIH)
Source: Click here
News: Reserve Bank of India(RBI) has announced the setting up of an Innovation Hub under the chairmanship of Kris Gopalakrishnan.It has also selected two entities for testing products under regulatory sandbox structure.
- Aim: To create an ecosystem that would focus on promoting access to financial services and products and will also promote financial inclusion.
- The Hub will collaborate with financial sector institutions, technology industry and academic institutions and coordinate efforts for exchange of ideas and development of prototypes related to financial innovations.
- It would also develop internal infrastructure to promote fintech research and facilitate engagement with innovators and start-ups.
- Regulatory Sandbox: It is an infrastructure that helps financial technology (FinTech) players live test their products or solutions before getting the necessary regulatory approvals for a mass launch.
Effectiveness of Monetary Policy in India | Nov. 11th, 2020
What is Monetary Policy?
- Monetary policy is the process by which the RBI controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability.
- Quantitative Instruments: General or indirect (Cash Reserve Ratio, Statutory Liquidity Ratio, Open Market Operations, Bank Rate, Repo Rate, Reverse Repo Rate, Marginal standing facility and Liquidity Adjustment Facility (LAF))
- Qualitative Instruments: Selective or direct (change in the margin money, direct action, moral suasion).
Recent trends: RBI a few ago released its monetary policy report (MPR)
- The repo rate (the rate at which the RBI lends short-term funds to commercial banks) stands at 4.0 percent and the reverse repo rate (the rate at which the RBI borrows) stood at 3.35 percent.
- As per RBI, transmission to bank lending rates has improved as evident from the decline in the lending rate of banks on fresh loans.
- Rise in food Inflation owing to floods in eastern India, lockdown-related disruptions and cost-push pressure, etc.
- Global financial market volatility caused by the impact of the COVID-19 is most likely to exert pressure on the Indian rupee.
- Real Gross Domestic growth will remain negative for the whole 2020-21 period.
|Monetary Policy Committee:|
The idea of MPC was mooted by Urjit Patel Committee.
- Informal Indian economy: The monetary policy affects only around 60% of loans/credit in the Indian economy which are sourced from formal channels (Banks and NBFCs).Challenges to Monetary policy functions of RBI:
- Supply chain disruptions: The MPC uses CPI inflation to adjusts its policy rates. However, the CPI doesn’t factor the rise in inflation driven by supply-chain dislocations. For example, restriction on movement resulted into a shortage of essentials.
- Weak policy transmission: Both the government and the RBI are concerned that the cumulative easing has not yet been reflected in the lowering of their lending rates by banks.
- Limitation of Inflation targeting: Inflation has been accompanied by declining borrowing in the formal sector likely affecting investment leading to rise in unemployment (according to NSSO, unemployment in India has been highest in the last 45 years).
- Triangular balance-sheet: In the aftermath of the IL&FS default in 2018, an additional dimension of liquidity and solvency of the NBFC sector has been added to the prevailing twin balance-sheet problem. Borrowing easy money cannot solve governance issues.
- Gold economy: The Indian household saves in gold/jewelry rather than financial instruments. This curtails RBI from effectively circulating money in the economy.
Is Inflation targeting a good policy?
- It is a monetary policy strategy used by central banks to maintain inflation within a specific range.
- Narasimham (2000) and Rajan (2007) Committees recommended the implementation of inflation targeting in India.
Inflation targeting as a good policy
- It increases the transparency and credibility of the central bank consequently allowing it to carry out its monetary policy more effectively.
- It helps to stabilize inflationary expectations in an uncertain future.
- Increases the focus on domestic considerations and enables quick response to domestic economy shocks.
Limitations of Inflation targeting policy
- The policy doesn’t address the sudden shocks in the economy and inefficient transmission mechanisms.
- Too much weight to inflation stabilization might prove detrimental to the stability of real economy and other growth objectives.
- Requirement of Number of preconditions like well-developed technical infrastructure for forecasting, modelling and data availability etc.
- India lacks suitable conditions for successful implementation of inflation targeting. For example, lack of adequately developed financial markets, confidence of global capital markets is low, independence of the RBI etc.
- Policy of inflation targeting will lead to highly unstable and inappropriate exchange rate.
Need for independent MPC:
- To form credible governance policy: RBI should be independent to decide on the precise corrective action for banks with high NPAs, the desirable state of liquidity and the prudential norms to be observed by banks.
- To ensure low and stable inflation: For instance, Governments use pro populist policy before elections to provide a short-term boost to growth. This often leads to long-term inflation.
- Sustain Credit availability: To ensure adequate flow of money and credit to required areas.
- To prevent sudden appreciation and depreciation of currency. For example, In Turkey lira had depreciated over 80% against the dollar in the 12 months due to government interference.
- Sustainable Investments: Independent MPC will boost the investors’ confidence and will enhance credit ratings there by attracting more investments.
- To avert crisis: Mismanagement between fiscal and monetary policy led to increased Sovereign debt in developing economies. For Example, Greek Crisis.
- Develop a legal process to ascertain RBI’s responsibilities and accountability.
- Ensuring RBI’s autonomy: The governor should be made responsible and accountable to Parliament. The RBI act should be amended to provide a guaranteed tenure of the governor and deputy governors for their effective functioning.
- Change in policy: There is need to look at an indicator of inflation that excludes food and fuel and include structural factors responsible for price rise.
- Cooperation between Government and RBI: There should be mutual cooperation and coordination between RBI and Government in large at public interests for an efficient and sustainable economy.
Reserve Bank of India (RBI) governance
Context– RBI has to answer to Parliament why it misses the inflation target and what plans do they have to control inflation.
What is Inflation targeting and what happen when RBI fails to meet inflation target?
- Inflation targeting involves using monetary policy to keep inflation close to the agreed target. RBI and Government of India signed a Monetary Policy Framework Agreement in February 2015.
- As per terms of the agreement, the objective of monetary policy framework would be primarily to maintain price stability (inflation targeting), while keeping in mind the objective of growth.
- Target given to MPC:The Reserve Bank of India’s (RBI) MPC was given the target of keeping inflation at 4% +/- 2%. This meant that inflation should be between 2% and 6%.
- Condition for failure of inflation target – A breach of the tolerance level for three consecutive quarters will constitute a failure of monetary policy.
- In such case– RBI have to send a report to the central government stating reasons and the remedial actions it proposes to initiate, and an estimate of the time-period within which it expects to achieve the inflation target through the corrective steps proposed.
- Aim– To enhance transparency and accountability of the central bank.
What was the reason proposed by RBI for the breach of inflation target?
- Lack of Data due to lockdown– The MPC is of the view that there was a break in the consumer price index (CPI) series since inflation data for April and May was imputed and not collected by visiting the markets by NSO surveyors. It was rather estimated by the NSO.
However, Prices could be collected from the urban markets and villages after lockdown restriction were lifted and non-essential activities partially restored.
- The central bank needs to answer three questions — why it has failed to achieve its target; what remedial measures it would take to bring inflation back within the target range; and by what time.
- Transparency can enable more informed decision-making within the government, greater public scrutiny of the RBI’s performance, and an improved inflation-targeting regime.
Base year of CPI-IW changed
The Labour and Employment Ministry on Thursday revised the base year of the Consumer Price Index for Industrial Workers (CPI-IW) from 2001 to 2016.
Why the base year for the Consumer Price Index for Industrial Workers(CPI-IW) has been changed?
Due to the changing consumption pattern, more weightage has been given to spending on health, education, recreation and other miscellaneous expenses while the weight of food and beverages has been reduced.
Consumer Price Index (CPI) for Industrial Workers
It measures changes in the price level of a market basket of consumer goods and services purchased by households.
CPI data is released monthly by the Central Statistics Office (CSO) which functions under the Ministry of Statistics and Programme Implementation.
There are four types of CPI: a) CPI-IW (Industrial Worker), b) CPI-UNME (Urban Non-Manual Employees), c) CPI-AL (Agricultural Labourers) and d) CPI-RL (Rural Labourers)
RBI has adopted CPI as the key measure for determining the inflation situation of the Indian economy on the recommendation of the Urjit Patel Committee.
Usage of CPI-IW
CPI-IW is used:
- To regulate the dearness allowance (DA) of government staff and industrial workers.
- Apart from measuring inflation in retail prices.
- To revise minimum wages in scheduled employments.
After this Index, the government is expected to announce a new series of the CPI for agriculture workers, which is currently using the base year of 1986-87.
Need for Base years
Base years are required to facilitate inter-year comparisons of various data. if an index is using 2011-12 as the base year, data of all future years will be calculated based on the data of the index in 2011-12, for the purpose of comparison.
Example: Let’s say the cost of a basket of goods in an index was Rs 6 lakh in the base year (2016), and has been set to an index value of 100. If in 2017, the basket cost has been increased to Rs 6.6 lakh, the index equivalent would be 110.
The inflation rate will be computed by comparing 110 which is today’s value to the base value which is 100, resulting in a 10% increase.
Base years are used to nullify the impact of inflation on the data and project the actual estimates.
Thus, for selecting a year as the base year, certain requirements should be fulfilled, such as:
- The year must be a normal year and not have experienced any abnormal incidents such as earthquakes, droughts, floods, etc.
- No abnormal economic activity like Hyper rise in price should have taken place.
- Base year should not be very far from the current year.
India’s inflation targeting policy (Monetary policy)
Source – Live Mint
Syllabus- GS-3 Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.
Context- Inflation targeting and the decisions of Monetary Policy Committee (MPC).
What causes inflation?
The primary cause of inflation is the mismatch between demand and supply. The mismatch can be in following context-
- Excess money supply that raises aggregate demand
- Supply deficiency (A shortfall in the production of a commodity fails to meet even the basic needs of the citizens and thus prices raise causing inflation).
What is the new monetary framework?
The agreement between the Reserve Bank of India (RBI) and the central government signed in February 2015. The agreement explicitly made inflation targeting the objective of the MPC while using the repo rate as the instrument for it.
- Rate steady– The Reserve Bank’s MPC was given the target of keeping inflation at 4% with a tolerance limit of 2%. This meant that inflation should be between 2% and 6%.
- Contrasting target – The target was in contrast with the multiple indicator approach that predated this framework where the central bank focused on both growth and price stability.
Thus, RBI was finally free to do its core job as guardian of the rupee’s value and granting currency the stability needed to serve as a credible unit for long-range forecasts.
What is inflation targeting? What are the views of critics?
Inflation targeting refers to keeping inflation rate within the permissible band so that business houses can plan their investment activities.
- Review meeting– (every two months): Where MPC discuss the likely inflation and growth estimates over the coming months.
- Targeting inflation: Based on this review, the MPC targets inflation using the policy rate, or the repo rate.
- Inflation targeting was ill-suited to an emerging economy like India.
- Flexible regime with a wide inflation band was far too rigid to foster growth.
Inflation in India has been subdued since the new monetary policy framework was brought in. Many view this as a sign of its success in India while others point at the tight policy and its adverse impact on India’s growth rate as a sign of problems with the framework, which has come at the cost of growth.
Centre must not act in haste to abandon inflation targeting. Price stability is a goal too worthy to give up on. For the sake of fairness, if not the rupee, government should resist the temptation to use the “money illusion” of inflation for short-term ends.
Demand to Rework Inflation Targeting Regime
Source: Indian Express
Gs3: Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment.
Context: Recently the monetary policy committee (MPC) concluded that elevated inflation has constrained it from easing policy rates.
Why there is demand to rework inflation targeting regime?
- Economy slowdown:Since the growth rate is falling that is why question have been raised regarding the inflation targeting framework.
- Growth-inflation quagmire:there is demand for the government to relax the inflation targeting framework to spur growth and demand.
- Greater tolerance for higher levels of inflation either by adjusting the acceptable range of inflation upwards, or by extending the period over which the MPC has to meet its inflation target.
- Shift from headline to core-inflation as the nominal anchor of monetary policy.
- Incorporate other indicators such as nominal GDP explicitly into the framework.
- Doing away with the inflation targeting framework altogether.
What are possible way outs and their implications?
Easing policy rate:
- It will inject a degree of uncertainty and unpredictability in monetary policy.
- Frequent revisions will destabilise household expectations.
- It will signal a lack of commitment to maintaining price stability.
Shift to a multiple indicator structure:
- This move harks back to the pre-MPC days when there was far greater uncertainty over monetary policy.
- No clarity over the indicator that was dictating the stance of the RBI governor.
- Absence of a well-defined anchor will reduce transparency and accountability from the central bank.
Central bank financing the Centre’s capital expenditure on a regular basis.
- Monetisation should be the last resort: The perils of falling back on this long-discarded policy need to be guarded against.
- Tilt the balance of power in favour of the government: Government owing to its short-term political imperatives will be seduced by the apparent simplicity of this idea without considering its long-term repercussions.
- Channel funds to revenue expenditure:It will lead to a situation wherein the entire budgeted capital expenditure is financed by the central bank.
- Blur the line between fiscal and monetary policy :Giving a central bank a degree of control over the government’s expenditure priorities will allow unelected technocrats to be in charge of determining the expenditure priorities of the government. It will result in the fiscalisation of monetary policy.
Pledge Government shares in companies to avail loans against them:
- It raises questions whether a sovereign should pledge assets to borrow in the local currency.
- In 1991, India had pledged gold for a foreign currency denominated loan not a local currency loan.
- There is not clarity on what will happen if the value of the shares pledged falls below that of the loan.
What is the way forward?
- There is need topush for more external voices in the MPC. For instance, In the UK, a non-voting treasury representative sits with the MPC to discuss policy issues.
- During periods of extreme uncertainty, there is need to adopt some unconventional measures but the principles of sound public policyshould not be discarded.