Column: RBI governor versus the report

Written by Renu Kohli | Updated: Jan 27 2014, 05:20am hrs
The widely-awaited Patel committee report to revise and strengthen RBIs monetary policy framework, the first of RBI Governor Raghuram Rajans five pillars of focus, was released recently. It recommends wide-ranging changes, significant amongst which are: a shift to flexible inflation targeting (FIT), making price stability the predominant objective ahead of growth and financial stability; adoption of headline CPI as nominal anchor (medium-term inflation target - 4% in a 2% band); wider decision-making structure with a formally constituted committee and voting; phased changes in the operational framework, including transfer of debt management to the government; and institutional reform on the fiscal side to eliminate financial repression, viz SLR, administered interest rates, and so on.

Most market analysts, excepting a few, have welcomed the key recommendations with the presumption that Governor Rajan will readily accept those within the purview of the central bank without much debate or delay. Expectations are he could possibly give some lead in tomorrows monetary policy review itself. At the top of their expectation agenda is a formal announcement to shift to flexible inflation targeting (FIT) with headline CPI as the nominal anchor. In anticipation, bond yields firmed up last week, reversing an easing trend observed since the sharp correction in December headline inflation.

Without going much into the merits or demerits of these recommendations, we would like to focus on how far the market is right in its belief that Governor Rajan will readily accept and implement these without more debate or discussion. If, indeed, these policy actions were in the pipeline, as the market has anticipated ever since he took charge at Mint Street, then what led Governor Rajan to express his views on these very issues, some of which were in complete contrast to the committees recommendations, in a few press interviews just a month before the reports formal release Given that these views were more practical and accommodative of Indian realities compared to that of the Patel report, it merits highlighting the divergence: Flexible inflation targeting recommended by the committee makes price stability the primary objective with a 2 percentage point band to accommodate temporary shocks, other concerns etc. The theoretical underpinning of its analysis is the new Keynesian framework of monetary policy that works via the inflation expectations channel.

The Governor, on the other hand, displayed a rather practical mindset keeping in mind that India is a developing economy. Heres what he says: in a situation of relatively high inflation and low growth, we have to be a little more practical than theoretical People who advocate a rate hike because inflation is very high, even without the food component, have in mind some developed-economy structure. (Business Standard, December 23, 2013).

In response to criticism from inflation hawks over his decision to hold the policy rate on December 18, he retorted their argument that: you have to raise interest rates to such a high level that it leads to strong expectations that inflation will come down. That kind of discussion is based on developed economies where the expectations channel works well. (Economic Times, December 24, 2013). Higher interest rates, instead he argued, would: feed through much lower demand, rather than people suddenly waking up and saying that RBI is really serious about inflation, therefore we should all curb our wage demands, and therefore it should bring down inflation.

Elsewhere (Business Standard, December 23, 2013) the expectation channel is much less understood. You raise interest rates up to a certain level and people start thinking the economy has slowed considerably and will earn them less in terms of wages, etc. People who are saying you should raise rates because inflation is very high, even after taking out food, have in mind some kind of developed-economy structure.

Critically, different views emerge on the choice of nominal anchor. The Patel report rejects the older WPI as incomprehensive and subject to large revisions, suggesting this should be replaced by the combined, new CPI measure. The time-frame for transition to the 4% target, it says, should be 2 years (current 9.87%).

The Governor, by contrast on if there was a case for a WPI-CPI shift, said, I think, for now, we have to work with both WPI and CPI partly because we dont know how the components of CPI will behave, as the history of CPI is short. There is also some scepticism about data quality. We have more comfort with WPI. But CPI is what the person on the street sees. So, I think we have no option but to look at both. We have to bring CPI down because we are not comfortable with such levels. But I am avoiding setting targets because I dont know how CPI behaves. The Urjit Patel committee will give its opinion on that. RBI has a tradition of looking at WPI and that tradition will continue. But we are also saying CPI matters and we need to bring CPI down. (Business Standard, Ibid). Again, on the debt management agency, which Patel report says should transfer to the government, the Governor says, To my mind, the conflict of interest issues are overblown on either side. If it is in RBI, there will be some conflicts of interest, if it is in the finance ministry, there will be some other conflicts of interest. The precise location of the DMO is not the central issue. The issue is to get the capabilities to man that office. And, I believe, right now, the capabilities lie with RBI. The RBI personnel will be involved in manning that debt office, at least for the foreseeable future. When capabilities emerge in the government or the finance ministry, there could be a discussion on who mans that office.

In fact, a careful reading of Governors various interviews in the last few months led one to believe that he would be more comfortable walking a tighter path, balancing growth and inflationary concerns; views that were more practical, slowly consolidating in him through his experiences of working in North Block and Mint Street for the last one year, rather than throwing his entire weight behind a model to target inflation, a model he himself favoured in his 2008 report and whose success is linked to a few key assumptions workable in advanced economies and backed by robust data.

Whatever might be the Governors final views on the Patel committees recommendations and to whatever extent he might be able to carry the government of the day along with these, RBI must clarify its stand much earlier on these issues for the market has waited far too long in anticipation, which itself has become a source for market volatility. Having interpreted the Governors end-December remarks as signalling a pragmatic policy stance, markets have now taken fear since the reports release, with most expecting interest rates staying elevated for a prolonged period. At a time when the central bank is battling inflation in a very weak economic context, confusing signals like these cause uncertainty, are disruptive and unaffordable at this juncture. RBI should reconcile this divergence in views, coming out clearly as to what is going to be its monetary policy framework going forward.

The author is a New Delhi-based macroeconomist