Context

• In a surprise move, the Indian central bank decided to pause its consecutive rate hikes and keep the benchmark repo rate at 6.50%.
• The decision taken by the monetary policy committee (MPC) is a unanimous one despite inflation still beyond tolerance levels and downside risks from global economic activity.
• Thus, this edition of the burning issue will talk about this hike pause and the mechanism of inflation targeting.

Background: Evolution of Inflation Targeting Framework

Phase One: Non-Statutory Inflation Control By RBI

• Non-statutory: This Phase was marked by a Non-statutory inflation mechanism by RBI which included changes in several policy rates such as cash reserve ratio, and statutory liquidity ratio to maintain inflation.
• Limitation: The mechanism lacked in several points such as lack of transparency in decision-making, uncertainty in the market about rates and inflation etc. Thus, the government shifted to Inflation targeting.

Phase Two- The MPC and The Beginning of the Inflation Targeting Era

What is the Monetary policy committee (MPC)?

• Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments under its control to achieve the goals specified in the Act.
• Six-member committee: Under Section 45ZB of the amended (in 2016) RBI Act, 1934, the central government is empowered to constitute a six-member Monetary Policy Committee (MPC).
• The primary objective: Section 45ZB of RBI Act, 1934 sets the objective of the RBI’s monetary policy to maintain price stability while keeping in mind the objective of growth.
• A Monetary policy committee was formed to decide the Key policy rates.
• Objective: Further, Section 45ZB lays down that “the Monetary Policy Committee shall determine the Policy Rate required to achieve the inflation target”.

Flexible Inflation Targeting Framework

Now, there is a flexible inflation-targeting framework in India (after the 2016 amendment to the Reserve Bank of India (RBI) Act, 1934).

What is Inflation Targeting? 

• Inflation targeting is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation.  
• Inflation targeting was first adopted in New Zealand and subsequently by 33 other countries. India adopted it in 2016.
• The amended RBI Act, 1934 provided for the INFLATION TARGET (4% +-2%) to be set by the Government of India, in consultation with the Reserve Bank, once in every five years.

3 Stances of RBI under Inflation Targeting

1. ‘Accommodative’ 

• An accommodative stance means the central bank is prepared to expand the money supply to boost economic growth. The central bank, during an accommodative policy period, is willing to cut interest rates. A rate hike is ruled out.

2. ‘Neutral’

• A ‘neutral stance’ suggests that the central bank can either cut rate or increase rate. This stance is typically adopted when the policy priority is equal on both inflation and growth.

3. ‘Hawkish’

• A hawkish stance indicates that the central bank’s top priority is to keep inflation low. During such a phase, the central bank is willing to hike interest rates to curb the money supply and thus reduce the demand.

How inflation and rate hikes are linked?

• When there is a shortage of funds, commercial banks borrow money from the central bank which is repaid according to the repo rate applicable.
• The central bank provides these short terms loans against securities such as treasury bills or government bonds.
• This monetary policy is used by the central bank to control inflation or increase the liquidity of banks.
• The government increases the repo rate when they need to control prices and restrict borrowing.
• An increase in repo rate means commercial banks have to pay more interest for the money lent to them and therefore, a change in repo rate eventually affects public borrowings such as home loans, EMIs, etc.
• From interest charged by commercial banks on loans to the returns from deposits, various financial and investment instruments are indirectly dependent on the repo rate.

Why RBI hiked rates previously?

• Global economic volatility due to the Ukraine war since March 2022 supply chain disruptions for a number of items.
• Record high inflation throughout a major period during 2022 has prompted the RBI to make multiple policy rate hikes.

Impact:

• The RBI has raised the repo rate by 250 basis points (bps) since May 2022, thereby increasing the External Benchmark Linked Interest Rates, EBLR by 250 bps.
• Banks have also raised the lending rate linked to the marginal cost of funds-based lending rate (MCLR) in the past 11 months.
• Last year, the Consumer price index (CPI) hit its highest of 7.79% in Apr, and the wholesale price index (WPI) reached 15.88% in May 2022.

Why RBI has now paused hikes?

• Decreasing inflation: The country’s retail inflation, which is measured by the consumer price index (CPI), slipped 16-month low of 5.66% in Mar. 2023.
• Inflation data on the Wholesale Price Index (WPI), which calculates the overall prices of goods before selling at retail prices, was at 3.85% in Feb. 2023.
• May slow down growth and consumption: Concerns over slowing consumption and tepid private investment have been emerging in policy quarters, with many seeing high-interest rates as a crucial factor in dampening demand.
• Decrease in crude prices: Also, there has been a decrease in global crude prices and food inflation.
• Still risks are there: The RBI underlined risks from protracted geopolitical tensions, tight global financial conditions and global financial market volatility to its monetary policy outlook.

Will this pause be helpful or not?

(1) Yes

• The pause by the RBI will help favor the growth-inflation tradeoff towards the former.
• An increase in EMIs for different types of loans will also halt helping the middle class to cope with inflation.

(3) No

• Rates to remain high: In the backdrop of many global agencies lowering India’s growth forecasts for this financial year amid expectations of global economic slowdown and monetary tightening by other countries.
• No relief on debts: The interest rates of debts are already high and a pause on a hike will not bring down these interest rates and thus keep the debt costlier.

Effectiveness of Inflation Targeting

Successes

• Average inflation has declined: The average inflation rate measured through the GDP deflator has declined significantly in the inflation targeting regime.
• The average inflation, which was 5.69 per cent five years in the pre-inflation targeting period, has declined to 3.47 per cent in the last five years.
• CPI declined: Consumer Price Index inflation declined from 8.26 per cent during the 2011-2015 period to 4.99 per cent in 2016-2019, a 3.27 percentage point fall.
• This is highest among both inflation-targeting countries as well as those that did not adopt it.
• Enhanced transparency:  Monetary policy transparency in India has improved after the adoption of the inflation-targeting framework.

Failures

• Sole focus of inflation: However, some critics of inflation targeting feel that its sole focus on price stability ignores growth imperatives.
• Not much effective in India: In India, the agricultural sector and informal economy have a large share, which is not directly impacted by such rate hikes, thus rendering the hikes less effective.

Way forward

• The review committee should try to find out areas of further improvement in the monetary policy framework which will strengthen the MPC to achieve the inflation target.
• In the present framework, it is not clear which model the RBI uses to forecast inflation and GDP figures, so it should disclose the models used in forecasting as other inflation-targeting countries do.
• Further, the RBI may include a forecast of core inflation in the minutes.

Conclusion

• Central banks including the RBI are often accused of falling behind the curve. However, these are challenging times for central banks. Rate hikes operate with a lag. They also lead to a growth slowdown.
• Thus, RBI has to walk a tightrope to balance growth-inflation dynamics. The accountability measures incorporated in the inflation targeting framework ensure that the focus on inflation management is not lost.