Issues with MPC’s inflation targeting: Business Line 13th March 2020

The monetary policy committee needs more clarity on what form of inflation to target, and whether growth is a factor

There is some talk of the review of the Monetary Policy Committee (MPC) framework, which is quite logical given that it has been in operation since October 2016 and calls for stocktaking. The MPC has worked well given the mandate which was clearly spelt out in terms of targeting a CPI inflation number of 4 per cent per annum with a band of 2 per cent on either side. This was supposed to be the single goal of the committee, and at times, has been held sacrosanct.

However, with these broad contours being maintained, the MPC has chosen to generally decrease the repo rate even while the direction of inflation may not have been downwards. If one were to review the issues which can be revisited, then the following can be considered, assuming that it is accepted that monetary policy can influence CPI (which is debatable as about 85 per cent of the weight is not affected by interest rates).

The first is the inflation target per se, which was fixed at 4 per cent. Is this the most suitable number? If one looks at the trend in inflation, based on the 2012 series, CPI on an average was 7.54 per cent between 2012-13 and 2015-16 — which was the last year before the mandate became law. Subsequently, it has averaged 3.84 per cent.

While the MPC can be happy with the number during its tenure, the basis of 4 per cent may have been a bit ambitious given the past readings. In fact, CPI inflation for industrial workers (2001) for the 10-year period prior to October 2016 was 8.53 per cent which came down to 4.22 per cent subsequently. Interestingly, in none of the 10 years was inflation lower than 4 per cent and the lowest reading was 5.65 per cent in FY16. For the new series too, the sub-4 per cent number was registered in FY18 and FY19.

Therefore, if headline inflation is to be revisited, clearly, the 4 per cent number needs to be changed as it does appear that the lower readings have been more due to serendipity than structural reasons.

 

Core or headline?

The second is whether we should be looking at core inflation or headline inflation? The argument is that monetary policy cannot affect food and fuel inflation which are supply-side factors and hence, targeting core inflation makes sense. Here too the numbers are interesting. Prior to formally launching the MPC, the core inflation numbers were above 4 per cent and have been above this mark for all the years as shown in the Table.

Non-core inflation had moderated overall inflation post MPC in all three years with lower readings. Therefore, if the MPC targeted the core CPI index which showed higher numbers relative to headline inflation in all the three years, the recommendations could have been different.

A clearer inflation target would help the markets as at times when rates were lowered, it was a case of core inflation going up but non-core coming down while of late, it has been the opposite where core has come down but non-core increased.

Third is how should policy response be poised? This is important because the MPC meets six times a year and the decision is based on monthly y-o-y inflation numbers which is combined with the outlook for the future. The outlook has been for half years or quarters in the coming months and may not be necessarily aligned with the decision taken.

The market always wants to know that if inflation moves from 4.5 per cent to 4 per cent, does it warrant a cut in interest rates or stance. Alternatively, if it moves from 4.1 per cent to 4.6 per cent should rates be increased and stance changed? This is presently left to the discretion of the majority decision of the members which leads to the next issue on growth.

Fourth, should MPC be looking at growth and inflation or just the latter? The MPC presently targets inflation but also looks at growth and talks a lot on the output gap and the weakness in demand which has to be stimulated through some interest rate action. If this is the stance, then the mandate should change and also incorporate a growth target.

Just like how the FRBM talks of an escape clause if GDP growth slips 2 per cent lower than that of the past four quarters, the MPC should be asked to consider growth as an objective in case GDP slides by 1-2 per cent points lower in the preceding two quarters. This would make it easier to take a decision and reduce volatility in the market.

Policy effects

Fifth, should the MPC be evaluating the efficacy of past actions in every meeting? Models often show that policy effects are seen with lags of 4-6 quarters which clouds the picture as several developments take place in both other policies as well as economy.

There is need for the MPC to also specify a time-frame within which the rate action should work in terms of not just transmission but also impact on inflation.

If inflation comes down due to onions becoming cheaper, the causal effect is missed when the repo rate is linked to the price movement. Therefore, self-evaluation reports would also be useful to the market on a periodic basis.

Last, all MPC reports have never touched on the issue of savings being impacted and while there is a lot of talk on growth, this aspect has been given a miss. In this context, a view is that the size of the MPC should be expanded — at present it consists of three members from the central bank and three academicians.

The new members can represent industry (which can highlight concerns), a banker (to put forward the sector perspective), and a member to represent the public (which affect savings).

This will help bring in diverse opinions which can go into decision-making. The tenure of the existing economists should be fixed and members rotated to bring in fresh approaches.

As the process of monetary policy is always evolving, these thoughts could be incorporated in the framework.