Govt to introduce monetary policy framework with focus on flexible inflation targeting
Reuters | Photo Credit: Arun jaitley and Raghuram Rajan

The government and the Reserve Bank of India (RBI) decided to introduce a modern monetary policy framework with a primary focus on flexible inflation targeting. The government in a note released on Monday said that an agreement has been reached between RBI and the Ministry of Finance regarding the new monetary policy framework.

"It is essential to have a modern monetary policy framework to meet the challenges of an increasingly complex economy. The government and RBI are entering into an agreement to put in place such a framework," the note said.

The change to the framework comes into place following Modi government's initiative to bring GDP and CPI figures in line with the international standards. 

The framework brings in more transparency while holding RBI governor accountable in case the institution fails to 

achieve the inflation target. India has experienced high volatility in the prices in the past decade and has experienced high rates of inflation compared with other emerging market economies. The framework sets a target of 4 per cent for financial year 2016-17 with a band of +/- 2 per cent.

The agreement signed on February 20 states that while RBI governor and in his absence deputy governor would be in-charge of monetary policy and shall determine the policy rate. RBI would be required to publish a bi-annual document explaining the sources of inflation and forecasts of inflation for six-eighteen months. 

The agreement while setting accountability on the part of RBI states that the governor like his counterpart in Bank of England would be required to state the reasons in case of failure to achieve target and provide information on remedial measures and a time frame to achieve the inflation target. 

The government is expected to move towards formation of Monetary Policy Committee. Inflation targeting has gained significance in emerging markets which have long struggled with double digit rates of inflation. The main objective of MPC would be to decide on the policy rate for the country. 

While the government is expected to act on the formation of MPC, there are a few recommendations that it can follow. The Report of the Financial Sector Legislative Reforms Commission mentions the formation of MPC with seven members chaired by the RBI governor. It will have one executive member from the board of the central bank and five external members to be appointed by central government of which two would be in consultation with the chairperson. It also suggested that the decision would be made on a one-person one-vote basis and that each of the seven members will submit a rationale statement. The committee also recommended that with a lag of three weeks, voting record and all seven rationale statement shall be published. 

Urjit Patel committee report also commented the formation of MPC. The report laid a framework where RBI governor will be chairman of MPC, deputy governor in charge of monetary policy will be vice chairman and executive director in charge of monetary policy will be a member. Two other members will be external, to be decided by chairman and vice chairman on the basis of experience in monetary economics, macroeconomics, central banking, financial markets and public finance. Each member of MPC will have one vote with the outcome determined by majority voting, which has to be exercised without abstaining. Minutes of the proceedings of the MPC will be released with a lag of two weeks from the date of the meeting.

While the FSLRC report gives some role to the government, the Urjit Patel committee report nullified the role of the administration.

The formation of MPC is expected to bring India at par with the developed economies where rates are decided by MPC. In the US the rates are decided by the Federal Open Markets committee (FOMC) which consists of 12 members, seven members of the Board of Governors of the Federal Reserve System, president of the Federal Reserve Bank of New York and four of the remaining eleven Reserve Bank presidents. On the other hand in the UK, Bank of England's Monetary Policy Committee (MPC) is made up of nine members – governor, three deputy governors for monetary policy, financial stability and markets and banking, the bank's chief economist and four external members appointed directly by the Chancellor. 

The finance minister in his Budget speech had mentioned the introduction of the monetary policy framework and that the government shall make amendments to the RBI Act for formation of MPC. The step comes at a time when the RBI is expected to cut rates given that inflation is under control and the government is confident to meet its fiscal deficit target. 

Inflation figures for February would be released on March 12, 2015 while the RBI is expected to meet on April 7, 2015.

(Edited by Joby Puthuparampil Johnson)

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