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RBI panel wants retail inflation as new policy benchmark

January 22, 2014 08:53 IST

The Urjit Patel committee on monetary policy framework has proposed setting up of a monetary policy committee (MPC) that will be headed by the Reserve Bank of India (RBI) governor and accountable for achieving inflation target set by it.

The report of the Patel committee, set up by RBI in September last year, has recommended that retail inflation, measured by the Consumer Price Index (CPI), replace wholesale inflation as the price anchor. 

The responsibility of the central bank, the panel has suggested, should be to bring the retail inflation rate down at four per cent, with a variation of 200 bps on either side, in three years.

“The nominal anchor should be defined in terms of headline CPI (-based) inflation, which closely reflects the cost of living and influences inflation expectations relative to other available metrics,” the report has said.

If the MPC fails to achieve its target for three quarters in a row, it has to issue a public statement, mentioning reasons for failure and remedial measures, with signatures of all the five members.

Observers said if this practice was followed, the central bank would have valid reasons not to pay attention to any advisory from the government on its monetary policy stance. In recent times, finance ministers have repeatedly pressured the central bank to cut interest rates, even if the situation does not warrant such an action.

The observers also said the lines between the government and RBI were set to be re-drawn if the recommendations of the committee were accepted.

Indicating a shift from a discretionary policy to a rule-based one, the panel has advocated adoption of a policy rate that is easily communicated and understood; it will be positive when inflation is above the nominal anchor.

Since bringing down inflation from the current level is essential to move to this proposed framework, the panel has also laid out a road map for this. It has suggested that the current level of retail inflation — at 10 per cent — be brought down to eight per cent within 12 months and then to six per cent over the next 24 months, before the recommended target of four per cent is formally accepted.

Barclays Chief India Economist Siddhartha Sanyal said the committee had taken a very aggressive stance. “This could boost the credibility of RBI if, indeed, the targets are achieved. However, it will be a challenging task and will depend a lot on coordination with fiscal authorities,” he added.

The committee has also recommended that the government should ensure it brings down its fiscal deficit below three per cent of gross domestic product (GDP) by 2016-17 and does away with administered prices, wages and interest rates.

In what could be construed as paying more if the government’s market borrowing is high, the panel has said that RBI’s open-market operations should be only for liquidity management and not for managing yields — a practice widely followed now, though not formally admitted to.

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 toolkit, 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. It has said, “the government should eschew suasion and directives to banks on interest rates that run counter to monetary policy actions.”

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).

Detailing the MPC framework, the Patel panel has said the RBI governor will be the chairman, while the deputy governor in charge of monetary policy will be the vice-chairman and the executive director will be a member. Besides, there will be two external members who will work full time and have access to information/analyses generated within RBI. They cannot hold any office of profit or undertake any activity seen as amounting to conflict of interest with the working of the MPC. The term of office of the MPC will ordinarily be three years, without a prospect of renewal.

Each MPC member will have one vote and the outcome of any issue will be determined by a majority in voting — which will have 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.

The MPC will ordinarily meet once every two months and RBI will also place a bi-annual inflation report in the public domain. The MPC chairman will have a casting vote during exigencies. The committee will be asked to put out the bi-annual inflation report in the public domain on the basis of macroeconomic and monetary policy reviews.

The committee has also deliberated 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.


Highlights of Patel panel report
  • Nominal anchor: A shift to headline retail inflation
  • Road map: Cut inflation from 10% to 8% in one year; and to 6% in two years
  • Target: Retail inflation rate of 4% (+/- 200 bps)
  • Rule-based framework: To make conduct of monetary policy more predictable and transparent
  • Fiscal consolidation: Firm govt commitment  to cut fiscal deficit to 3% of GDP by FY17
  • Composition of monetary policy committee (MPC): RBI governor, a deputy governor, an executive director and two external members
  • Tenure of MPC: Three years (to meet once every two months)
  • Accountability: MPC to be responsible for meeting inflation target; to issue public statement with members’ signatures if it fails to achieve the target for 3 quarters
  • Phased refinement of operating framework: LAF, repo rate to continue as single policy rate in Phase-I; 14-day term repo will emerge as policy rate in Phase-II
BS Reporter in Mumbai