The Urjit Patel Committee report on monetary policy framework is voluminous and comprehensive with firm theoretical foundations. It puts forth a thought and argues the pros and cons and then takes a call, and hence looks at all aspects of the issue. It cannot be questioned for omission though the reader could have a different view. And, in economics, where several theories exist, stances are not singular.
If one asks whether the approach is monetarist, the answer is ?yes? as it targets inflation specifically. Is it Keynesian? The answer is ?no? because while it talks of the importance of growth, the focus is still on inflation-targeting. (What happens to India Inc, which is worried about interest rates coming in the way of growth?) Would it come under the rational expectations school? Yes and no. Yes, because it does prefer to give all information in advance though it leaves it to the committee to have the last word to provide the ?surprise element? or ?noise?.
Now, let us look at some points that provoke further thought. Targeting retail inflation, exclusively, in India is debatable. An index based on items which are not usually supported by credit like food, clothing, transport, etc, would not really be affected by policy measures, thus making it less effective. In developed countries, this makes sense as there is little difference between WPI and CPI as the system is efficient. In India, the variation could be between 2-3%. Also, credit cards are widely used to buy all goods which imply that interest rates can affect consumption, which is not the case in India. On the other hand, using CPI inflation to justify high interest rates is all right in the context of real interest rates, but policy can affect at best the WPI components. The report argues that WPI is incomplete and excludes services. But then how many prices of service products are driven by credit flows? The basis of monetary policy is excess demand driving prices a la Irving Fisher. Therefore, ideally, benchmarks should be set for both the inflation concepts.
Related to CPI inflation, targeting 4%? 2 percentage points is quite ambitious. CPI normally reigns higher than WPI which could at the best of times come in this range. By targeting CPI, we run the risk of moving asymptotically towards this mark but never getting there. This will create problems for the Monetary Policy Committee (MPC) which has to justify inflation when it has little control over these components.
At another point, the report argues how the government ought to keep wages in check as higher MGNREGA wages or higher MSPs have led to inflation. But rural wage hike has been linked to higher demand for food products which have not kept pace with supplies, thus leading to higher prices. Therefore, while such inflation will come in the way of monetary policy action when only CPI is targeted, policy measures per se would be impotent to influence such spending, thus blunting their efficacy. This will make it more difficult to administer policy?especially when there is a solitary goal which cannot be overridden by, say, the growth objective, something that is possible today.
The second area of interest relates to monetary policy transmission. The focus seems to be more on the overall environment in which we operate rather than the direct impact, as the repo cost for any bank is very small in the calculation of the base rate. It rightly points out that banks? decisions are affected by several other factors. Here, there are some provocative recommendations made. First, it argues that banks need support from distortions in the system caused by differential tax treatment on financial instruments such as FMP or small savings rates being fixed to G-Secs. Second, it wants a lower SLR which should be aligned with the Basel III requirements.
Two points can be made here. First, as mentioned in the report, banks hold excess SLR voluntarily. Therefore, to say that private sector is crowded out is not right as banks are willing takers. Second, banks prefer SLR as the returns are good and there is no fear of NPAs. Therefore, they hold on to SLR for sound commercial reasons. Given that another arm of RBI is fretting over NPAs, lower holding of G-Secs cannot be ordained by the regulator. However, if RBI is serious and feels strongly, it should put an upper limit for SLR-holding by banks and penalise any excess investments. Is RBI willing to do this?
A novel approach is to bring in-term repos aggressively which will be aligned to market conditions and will affect the base rate through deposit rates as well as help to regulate liquidity. This process has already begun and it needs to be seen how the term repo rate will replace the overnight repo rate in the medium-term.
Finally, there is a tilt towards RBI having more independence. This has been an ongoing controversy where various Governors have been typecast as being independent or compliant. At a more pragmatic level, the central bank is a facilitator of transactions and should ideally be in conversation with the government. The report is aggressive in suggesting a concrete wall (the MPC may not have government representation) between the two. But, to draw an analogy, the RBI is like the CFO who should fine tune the system to meet the expectations of the CEO (government), who has to take a broader economic, social and political view. Hopefully, such a structured approach, when accepted, will address this conundrum.
Madan Sabnavis
The author is chief economist, CARE Ratings. Views are personal
