Column: Soft adoption of a hard framework

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SummaryAligning policy rate to headline CPI inflation could dent investment and growth

The much-awaited Urjit Patel committee report on a new monetary policy framework was submitted last month. According to it, high and persistent inflation has got entrenched into consumers' psyche resulting in higher inflationary expectations as borne out by RBI surveys, the only one conducted in India. To break this psyche, the report opines that a new framework to focus only on one target, i.e., inflation—commonly called “inflation targeting”—is required. And for such a framework to be credible, RBI must have the mandate to raise policy rate to a level deemed appropriate to crush demand and allow inflation to stabilise at around a medium-term target.

The committee’s recommendation to completely overhaul the system matches Governor Raghuram Rajan’s perception that the old framework had outlived its utility as the institution seemed to have relapsed into a phase of self-doubt; a phase wherein it was no more convinced it could rely on WPI-headline inflation as the nominal anchor; raised questions whether the multi-indicator approach was able to adequately respond to the situation at hand; and became unsure if it had sufficient autonomy to conduct an effective monetary policy. The committee’s recommendations have broadly responded to these three key concerns.

Not surprisingly, RBI decided to implement two of the report’s key policy suggestions in its monetary policy review on January 28, even without formally announcing acceptance of all, or part, of its recommendations. Inflationary expectations would henceforth be anchored to headline-CPI inflation with a “glide path” to achieve a medium term target of 4% (± 2% range). While some analysts believe that by doing so, RBI has made its intent clear, others make a case that the regime is already into a zone that could be characterised as “inflation targeting light (ITL)”, a regime that kicks in the transition phase, to prepare ground for its full adoption at a later date.

We, however, are of the opinion that the Governor has only implemented the softer part of the recommendations of a very hard framework, which prescribes raising policy rate as much in the ruthless pursuit of its objective to bring down inflation. In fact, the report recommends that real policy rate should become significantly positive with immediate effect to make any meaningful dent to inflationary expectations. The real test, therefore, would depend on how soon the Governor is able to raise rates to a level that can deliver the required punch to knockdown CPI

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