The message is the aim

Indian Express, 6 May 2011

In the monetary policy statement earlier this week, the RBI changed its policy stance to a strong anti-inflationary one. However, this step, though much needed and in the right direction, will not be enough to bring inflation down. Hiking rates and contracting demand is only one part, the painful part of the story. An equally imporant element is public perception about the central bank. To build credibility on its anti-inflationary stance, RBI will need to improve its research capacity, communication strategy, get rid of conflicting objectives and be consistent in its pursuit of inflation control. This part, fortunately, does not hurt anyone. It needs a change in the framework, functions and objectives of RBI.

Not only are there long lags in the weak monetary policy transmission mechanism in India, the bigger problem for the effectiveness of the tigher monetary policy is that RBI is yet to build credibility as a central bank that puts inflation control above all objectives. To control inflation it will need to build this credibility by consistent pursuit of inflation control as its primary function. To consistently pursue inflation control as its objective, RBI will have to get rid of conflicting objectives like maintaining the competitiveness of exports and of being the government's debt manager. Given its poor record on projecting inflation in the last two years, it will have to visibly create new research capacity that is able to forecast future inflation and measure inflationary expectations better.

Considering its past of exchange rate pegging, it is not enough that RBI has stopped intervening in the foreign exchange market, it has to communicate its new framework and make a clean break from the framework of exchange rate pegging and multiple objectives. In the past RBI has prevented liberalising financial markets for both domestic and foreign particpants for fear of bringing in capital flows and making it difficult to prevent volatility in the foreign exchange market. Preventing financial markets from developing have not allowed the monetary policy transmission mechanism to strengthen. As a consequence, even when RBI has been tightening policy over many months, the tightening has not yielded results. RBI has to become a central bank that actively seeks to improve the transmission mechanism of monetary policy through developing the bond-currency-derivatives nexus. Once public perception about RBI changes, the effectiveness of monetary policy in India will improve.

What should be RBI's next step, even before the rate hike? First, if inflation control has to be the dharma of the central bank, the RBI must attempt to get rid of all those functions that might conflict with the objective of inflation control. In the past, it is some of these conflicting objectives that have come in the way of inflation control. For example, if keeping Indian exports competitive by manipulating the exchange rate had not been an important object of RBI policy, the period from 2004 to 2008 would not have witnessed the buildup of reserves and the consequent increase in liquidity that it did and inflation might arguably have be quite different. Indeed, the RBI would have prefered an appreciating rupee to keep prices under control. Similarly, if the RBI did not have the responsibility of being the debt manager of the government and keeping its interest expenditure low, it might have raised interest rates more sharply last year. Even though RBI has moved to a floating rupee, it has shied away from making a commitment that it will not go back to intervening in the foreign exchange market. The market does not believe that if the rupee hits Rs 40 to a dollar, the RBI will still be wedded to inflation control. It is becasue of such conflicts with the objective of inflation control that most central banks in advanced economies no longer intervene in foreign exchange markets or act as the government's debt manager. RBI cannot build credibility as a central bank focussed on inflation if it continues its present stance of arguing that it will continue to have multiple objectives and will somehow manange these objectives when a conflict arises.

Second, RBI's communication on the inflation needs to change. First, on the tradeoff between growth and inflation, RBI has often argued that inflation targeting means that a central bank must ingore all other objectives such as growth in employment. The present policy statement has seen a break from this framework. The RBI has acknowleged that the objective of high growth does not conflict with that of inflation control. Indeed high and volatile inflation reducing investment by introducing uncertainty and hurts medium and long term growth. This analytical framework needs to become RBI's main message.

Next, to build credibility, RBI should state its inflation measure and target. In the present policy RBI says: "Accordingly, the conduct of monetary policy will continue to condition and contain perceptions of inflation in the range of 4.0-4.5 per cent, with particular focus on the behaviour of the non-food manufacturing component. This will be in line with the medium-term objective of 3.0 per cent inflation consistent with India’s broader integration into the global economy. " This is not enough. RBI needs to state which measure of inflation, such as the based on the Consumer Price Index, underlies this target. More, few people would find this objective credible. RBI can gain credibility by presenting how it is faring against this objective in the next policy announcement. A report, similar to the Bank of England report, including creating a framework where the Governor is questioned by Parliament if he fails to meet his targets, would help in bringing credibility to RBI's commitment.

Third, better conduct of monetary policy would also require creating a much stronger research capability for measuring inflationary expectations. For example, the present policy statement asserts that:

" Significantly, the stability of long-term yields, despite the current high rates of inflation, suggests that inflationary expectations remain anchored."

RBI's own data on inflationary expectations strongly contradicts this.

Fourth, a short, concise policy statement would be more effective than present statement which also includes other policy initiatives.

The above are some of steps that can be taken relatively painlessly in the fight against inflation that could last many quarters. If the RBI is serious about this fight, it needs to start on these urgently.

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