Amol Agrawal, The author teaches at Ahmedabad University
The Reserve Bank of India’s (RBI) new governor, Sanjay Malhotra, is going to chair his first Monetary Policy Committee meeting on February 5-7. One of the first question any new governor might ask is, what is the basis of the 4% inflation target? The answer lies in the Chakravarty Committee Report, which incidentally completes 40 years in 2025.
In 1982, then RBI Governor Manmohan Singh instituted a committee under Sukhamoy Chakravarty that submitted its report in 1985. The committee’s objective was to review the functioning of the monetary system, keeping the planning era in mind, and assess the interlinkages between monetary policy, fiscal policy, and the banking system.
Before looking at the committee’s recommendations, we need to understand the macroeconomic thinking of the times. After the Second World War, Keynesian ideas dominated macroeconomic thinking and policy that paid more attention on increasing growth and lowering unemployment, with inflation on the sidelines. The development of the Phillips curve showed that there was a trade-off between inflation and unemployment, and policymakers could lower inflation easily by allowing a little higher unemployment and vice-versa.
Not all the economists agreed to the prevailing wisdom. In 1968, Milton Friedman argued that there could be a temporary trade-off between inflation and unemployment but not a permanent one. Higher inflation feeds into higher inflation expectations, which kick off the inflation cycle. Friedman’s prophesy was proven right as the world economy suffered from both high inflation and higher unemployment in the 1970s. The macro thinking changed from Keynesian to monetarism, an idea that higher money supply leads to higher inflation. The role of monetary policy was to keep inflation at a low level by managing the growth rate of money supply.
Let us now come back to the Chakravarty Committee. It noted that the share of the public sector in India’s savings had risen from 8.5% in the First Five-Year Plan (FYP, 1951-56) to 23.2% by the sixth FYP (1980-85). Despite getting a higher share of resources, the government was resorting to deficit financing under which it issued ad hoc T-Bills to the RBI and got funds directly from the central bank. The share of deficit financing in public sector financing averaged 12-13% in most of the FYPs. The total interest liability had risen from Rs 604 crore in 1970-71 to Rs 4,850 crore in 1983-84. Average inflation rose from 4% in 1951-1971 to 9% in 1971-85. Higher inflation should lead to higher interest rates, but due to administered interest rates this was not possible.
Given the broad functioning of the Indian economy and the resurgence in monetarism, the committee argued that price stability should be an equally important goal for the monetary policy along with other national goals. It added, “We believe an average annual increase of no more than 4 per cent per annum in wholesale price index should provide enough room for relative prices to change over the years as may be necessitated by changes in investment priorities and technological developments.”
The committee noted that the main reason for high inflation was an increase in money supply, which in turn had increased due to deficit financing. The government should finance its plan expenditure by tapping public savings and making the public sector more efficient. Government borrowing should be based on market-driven interest rates and for achieving this, the government and the RBI should develop an active secondary market for government securities. The active secondary market will shift the government borrowings from the central bank to the public, thereby lowering deficit financing of the Budget. The committee also noted that post-bank nationalisation, geographic expansion had increased significantly but it had put a severe strain on the operational efficiency of banks.
The other major recommendation of the committee was that the RBI should adopt monetary targeting with government support. Thus, mid-1980s onwards, the RBI adopted monetary targeting with M3 as the target.
The 1991 reforms were a turning point. Finance minister Manmohan Singh carried forward the reforms suggested by the committee that he had formed as RBI governor. Another committee was instituted under M Narasimham to review the functioning of the financial system. The recommendations of both the committees were implemented gradually, creating the modern financial system we see today. The government took gradual steps towards decontrolling interest rates and abolishing deficit financing. The development of government securities markets and the repo rate transformed monetary policy.
Governor Malhotra will obviously notice how the monetary framework has changed since the Chakravarty Committee Report. Monetary targeting did not work on desired lines as measuring money was tricky due to continuous innovations that created more forms of money. Monetary targeting gave way to central banks changing interest rates to achieve inflation targets. New Zealand first experimented successfully in terms of targeting inflation with interest rates, which gradually spread around the world to become today’s inflation targeting framework. India transitioned to a multiple indicator approach in 1997 before adopting inflation targeting in 2016. The Urjit Patel Committee Report (2014) which shaped inflation targeting in India recommended a target of 4% with a band of 2%, a target first proposed by the Chakravarty Committee 40 years ago.