The Reserve Bank of India (RBI)'s transition to an inflation targeting framework was justified by two main premises. One, policy instruments work best when they are committed to specific objectives. A monetary policy framework that simultaneously pursues multiple targets risks under-achieving on all. Two, when specific targets are committed to, accountability improves. Monetary policy can then be judged primarily in terms of whether it has managed to control inflation or not. All the elements of the new framework are not yet formally in place. However, the communication from the RBI over the past several months suggests that it is targeting inflation as reflected by the Consumer Price Index (CPI). Specifically, it is aiming for a six per cent inflation rate by 2016 and then four per cent in the years following. Now, had inflation rates been above these benchmarks, these commitments would perhaps have provided stakeholders much-needed reassurance that monetary policy would strive to bring it down. However, clearly, that is not the case. The CPI inflation has been hovering around the five-per-cent mark for several months, even falling below it in April. Whether this is the direct result of the monetary policy stance is a moot question; certainly, favourable developments on energy and food prices have contributed significantly. However, it is not unreasonable to suppose the current moderation will likely persist for a while.
Apparently, the RBI does not share this assessment, which is why it is notably reluctant to lower interest rates. This is in spite of the fact that going by Governor Raghuram Rajan's benchmark of a 1.5 per cent real policy rate (the actual rate minus the CPI inflation), the policy rate is 100 basis points above where it ought to be. The business community and the finance ministry - perpetually in the habit of pestering the RBI for lower rates - have a justifiable position in this case. If indeed inflation has come down to stay, the very logic of inflation targeting requires that the policy rate be brought down. A real interest of 2.5 per cent may be too high to permit the revival of private investment.
There are two possible explanations for the RBI's reluctance to calibrate the policy rate to the current inflation situation. One is that it firmly believes that the moderation is a transient development and inflationary pressures will revive soon, particularly if the monsoon disappoints. The question here is whether this is a reasonable baseline projection. Many observers believe that it is not. The other is that after a long period of declining credibility about the RBI's commitment to controlling inflation, it cannot afford a possible jolt to its reclaimed reputation. If this is the case, it must realise that reputation risks could cut both ways. Whatever it may have regained as a result of its stance over the past year and a half can be quickly lost if it is perceived to be overestimating inflation risks.
