This article deals with ‘Inflation Targeting .’ This is part of our series on ‘Economics’ which is an important pillar of the GS-3 syllabus. For more articles, you can click here.
Urijit Committee Report
Urijit Committee was formed to revise and strengthen the Indian Monetary Policy Framework.
- While making Monetary Policy, RBI must target inflation only & nothing else (like increasing employment, Increasing growth, stabilising ₹-$ exchange rate).
- In inflation, use CPI instead of WPI.
- The RBI should try to get inflation at 4% with a band of +\- 2%.
- Make Monetary Policy Committee to make Monetary policy.
Side Topic: Earlier System- Focus on Multiple Indicators
Earlier, RBI was using multiple indicators to make Monetary Policy
- Exchange Rate
But this system wasn’t good because
- There was no clear anchor of what RBI was trying to achieve, reducing the accountability in case of failure.
- It makes the whole system prone to pressure groups.
Why Target of 4% inflation???
- Studies reveal that there is a sweet spot for a rate of inflation for any economy where it can achieve its largest growth potential. For the Indian Economy, that spot is 4%.
- Studies have also revealed that
- Minimum 2% inflation is necessary
- When inflation is greater than 6%, it negatively affects GDP & employment.
- Hence, RBI should try to achieve inflation of 4% with a band of +\- 2%.
- The agreement has been signed between RBI & Government of India for operationalising the modern monetary policy
- The agreement binds RBI to keep inflation (Consumer Price Index) pegged at 4% +- 2 %.
- If unable to achieve a target for consecutive 3 quarters, then RBI will have to explain the government reason for this.
- Takes Monetary Policy formation out of the vulnerability of populism during election seasons.
- It leads to stability in the inflation expectations.
- It makes RBI more accountable as if it fails to meet the inflation targets; it will have to explain reasons.
- Increases Transparency: RBI will publish the operating targets and an operational procedure to reach the target.
- In India, inflation is driven by food and fuel prices which the Monetary Policy doesn’t impact.
- The agreement is one-sided as RBI has bound itself to contain the inflation, but the government hasn’t committed to observing fiscal prudence.
- Limited success of Inflation Targeting in developing economies: Inflation targeting works best in developed economies and has had little success in the few developing countries as banks don’t depend on RBI for funds. Hence, banks don’t react symmetrically to lowering of Repo Rate by RBI.
Question: Should RBI have such independence, given it isn’t democratically elected?
- RBI avoids lavish spending by the governments.
- It helps in avoiding the use of monetary policy for achieving political goals. E.g., lowering interest rates before elections.
- It has been a worldwide trend that when Central Bank’s independence is decreased, inflation in the country increases. In Europe, Germany has the most independent Central Bank and least inflation, and Portugal has the least independent Central Bank and highest inflation levels.
- Since RBI and its members aren’t directly answerable to the people of the nation, it shouldn’t be given such large powers.
Monetary Policy Committee is the best solution to this debate because
- It will have the representatives of both Government as well as RBI.
- Both will act as checks and balances on each other. None of the organs can entirely dominate others.
Monetary Policy Committee (MPC)
After lengthy debate and tussle between Government, MPC has been formed
- MPC was formed after the Amendment of the RBI Act (Hence, it is a Statutory Body)
- It has been formed on the England and Israel Model, which has members representing both RBI and Government.
- 3 members are from RBI
- 3 members are appointed by the Government.
- Governor of RBI as the Ex-Officio Chairman with casting vote in case of a tie
- Government can send messages to MPC only in writing to maintain the independence of MPC.
- Central Government shall, in consultation with Central Bank, determine the inflation target in terms of CPI once every 5 years (for 2016-2020, the target is 2-6%).