Inflation range of 2-6% is appropriate for monetary policy: RBI report

Ahead of the review of the inflation target in March, the Reserve Bank of India (RBI) on Friday released the Report on Currency and Finance 2020-21, which suggested that the current mandate of 2-6 per cent inflation target for the monetary policy was appropriate and should continue for the next five years.  

The RBI moved to an inflation-targeting framework in 2016. Since then, the six-member Monetary Policy Committee (MPC) has met 22 times, and the target has served the country well in anchoring inflation, argues the report.  

Even as the foreword of the report has been written by RBI Governor Shaktikanta Das, the report is not the official view of the central bank.

The RBI strives to anchor the consumer price index (CPI)-based inflation at the medium-term target of 4 per cent, with a band of +/-2 per cent for operational flexibility. According to the mandate, if the central bank is not able to keep inflation within this range for three consecutive quarters, it has to justify to the government why it failed to do so. Last year, retail inflation overshot the upper limit for more than three quarters, given the pandemic situation.

The report argues that since advanced economies keep their inflation target unchanged at 2 per cent, notwithstanding persistent deflationary conditions, the lower tolerance band in India should not be less than 2 per cent.  

On the upper tolerance limit, “international experience suggests that countries with a large share of food in the CPI basket tend to have higher inflation targets and wider tolerance bands. Threshold estimates over a longer sample period work out to 6 per cent, beyond which tolerance of inflation can be harmful to growth”.

“Hence, the current tolerance band of +/-2 per cent may be retained, notwithstanding the central tendency emerging from the country's experience of lowering targets and narrowing bands over time,” the report said.

This band will be reviewed in March, alongside a change in the CPI base, household consumer expenditure survey, and census.  

Globally, inflation-targeting emerging economies have either lowered their inflation targets or kept their targets unchanged over time. “In India, however, the repetitive incidence of supply shocks, still elevated inflation expectations, and projection errors necessitate persevering with the current numerical framework for the target and tolerance band for inflation for the next five years," the report said.  

Advanced economies have no problem dipping below the zero per cent lower bound as they use their balance sheets as a tool in the absence of the interest rate as a monetary policy tool. Going to this extent is not possible for India.  

There are crucial changes happening, such as in terms of demography, income distribution, and falling growth rate, which are challenging monetary policy as an instrument of stabilization, even as rising protectionism, digitisation, and climate change pose new risks. The Covid pandemic, on top of that, will leave permanent scars, according to the report.

“Monetary policy has entered a twilight zone and until clarity emerges on the shape of the future, it is important to entrench its nominal anchor so that it can continue to perform its stabilising role,” it said.

The report also supported the conduct of the MPC in formulating the policy. In the meetings, the members exhibited varied views, and the casting vote by the RBI governor, which is needed in the case of a draw, was not warranted ever.

Three external members and three internal RBI members, including the governor, make the MPC. 

"By all metrics, there has been an absence of groupthink and there were no free riders," the report noted.  

Nevertheless, the report said the MPC should undergo some operational changes. These include limiting the shut period for the MPC to start seven days before policy announcement and end three days after the day policy is announced; staggering onboarding of external members on the MPC; having an official communication policy document for the MPC; releasing minutes within a week after the policy announcement; releasing policy at a prefixed and pre-announced time; maintaining the transcripts of the MPC meetings and its release with a lag of 5-7 years at a future date; providing a more explicit forward guidance on the interest rate path at a future date, as the projection process is strengthened further over time; and modifying the definition of failure from the current three consecutive quarters norm of inflation remaining outside the tolerance band to four consecutive quarters.

Currently, the edited minutes are published after 14 days of the policy and there is no provision of releasing the full transcript.  

According to the report, forward guidance has been an effective tool for policy makers in managing market sentiment and ensuring cooperative solutions consistent with the monetary policy stance. However, there remains several “daunting challenges” for the liquidity management framework.  

The challenges include rapidly shrinking uncollateralised segment of the money market, and whether there should be two rates (repo and reverse repo for example) or one floor rate. The monetary and liquidity operations should also be consistent with the publicly communicated stance, and the choice of instruments for managing capital flows have to be fine-tuned, it said.

“Effective resolution on these issues would remove the impediments to seamless transmission of policy signals and its propagation across the term structure of interest rates. For this purpose, an improved understanding of market microstructure issues and the challenges posed therein would enable informed policy making while retaining credibility," the report said.

Moreover, with the adoption of the 14-day variable rate term repo/reverse repo as the principal liquidity management tool, “the development of a term money market is an absolute imperative for establishing market-based benchmarks, which in turn would help improve transmission, particularly if bank deposits and loans are priced off these benchmarks”.