CPI should be the nominal anchor for the monetary policy framework

Benchmark interest rates should be set by an independent monetary policy committee

The Reserve Bank of India (RBI) has released the Urjit Patel Committee Report to revise and strengthen the monetary policy framework in India. The committee recommended that CPI based inflation should be the nominal anchor for the monetary policy framework. This nominal anchor should be set by the Reserve Bank as its predominant objective of monetary policy in its policy statements. The nominal anchor should be communicated without ambiguity, so as to ensure a monetary policy regime shift away from the current approach to one that is centered around the nominal anchor. Subject to the establishment and achievement of the nominal anchor, monetary policy conduct should be consistent with a sustainable growth trajectory and financial stability.

The nominal anchor or the target for inflation should be set at 4 per cent with a band of +/- 2 per cent around it (a) in view of the vulnerability of the Indian economy to supply/external shocks and the relatively large weight of food in the CPI; and (b) the need to avoid a deflation bias in the conduct of monetary policy. This target should be set in the frame of a two-year horizon that is consistent with the need to balance the output costs of disinflation against the speed of entrenchment of credibility in policy commitment.

In view of the elevated level of current CPI inflation and hardened inflation expectations, supply constraints and weak output performance, the transition path to the target zone should be graduated to bringing down inflation from the current level of 10 per cent to 8 per cent over a period not exceeding the next 12 months and to 6 per cent over a period not exceeding the next 24 month period before formally adopting the recommended target of 4 per cent inflation with a band of +/- 2 per cent. The Committee is also of the view that this transition path should be clearly communicated to the public.

Since food and fuel account for more than 57 per cent of the CPI on which the direct influence of monetary policy is limited, the commitment to the nominal anchor would need to be demonstrated by timely monetary policy response to risks from second round effects and inflation expectations in response to shocks to food and fuel.

Benchmark interest rates should be set by an independent monetary policy committee, and the Indian government should narrow its budget deficit to 3 percent of gross domestic product by March 2017, from a forecast of 4.8 percent this March, the committee recommended.

Administered setting of prices, wages and interest rates are significant impediments to monetary policy transmission and achievement of the price stability objective, requiring a commitment from the Government towards their elimination.

Monetary policy decision-making should be vested in a monetary policy committee (MPC), recommended the panel. The five member committee will consists of the Governor, Deputy Governor and Executive Director in charge of monetary policy and two external members chosen by the RBI. Each member will have one vote and the monetary policy outcome will be decided by majority vote. Further, the MPC will be accountable for any failure to establish and achieve the nominal anchor.

The MPC will be accountable for failure to establish and achieve the nominal anchor. Failure is defined as the inability to achieve the inflation target of 4 per cent (+/- 2 per cent) for three successive quarters. Such failure will require the MPC to issue a public statement, signed by each member, stating the reason(s) for failure, remedial actions proposed and the likely period of time over which inflation will return to the centre of the inflation target zone.

The panel has proposed a two-phased transition to the new operating framework. In the first phase, the weighted average call rate will remain the operating target and repo will continue as the single policy rate. It has emphasised the need for a spectrum of term repos of varying maturities, with 14-day as the anchor rate. In the second phase, the 14-day term repo will emerge as the policy rate.

To support the operating framework, the committee has recommended some new instruments in the monetary policy toolbox, such as a standing deposit facility. It has also called for market stabilisation and cash management bills to be phased out, since the government debt and cash management is being taken over by the government's debt management office. The report has also elaborated on the impediments for transmission of the monetary policy.

Among other impediments, the panel has proposed reduction in statutory liquidity ratio of banks, more frequent intra-year resets for small savings schemes and revisiting the issue of interest-rate subvention to the farm sector. The panel has also said all fixed-income financial products be treated on a par with bank deposits for the purpose of taxation and TDS (tax deducted at source). Open Market Operations (OMOs) should not be used for managing yields on government securities

The committee has also debated on the issue of volatile capital flows and suggested building up an adequate level of foreign exchange reserves. The adequacy should also to be determined by intervention requirement based on past experience.

With regard to inflows that are excessive in relation to external financing requirements and the need for sterilized intervention: (a) the RBI should build a sterilization reserve out of its existing and evolving portfolio of GoI securities across the range of maturities, but accentuated towards a 'strike capability' to rapidly intervene at the short end; and (b) the RBI should introduce a remunerated standing deposit facility, which will effectively empower it with unlimited sterilization capability.

Additionally, the panel stated that the RBI should engage proactively in the development of vibrant financial market segments, including those that are missing in the spectrum, with regulatory initiatives that create depth and instruments, so that risks are priced, hedged, and managed onshore.

Powered by Capital Market - Live News