After maintaining the status quo for nearly two years, the RBI has lowered the policy repo rate by 25 basis points, lowering it from 6.5 percent to 6.25 percent. The cut-first in five years- is justified, whether one looks at India’s own record over the last few years or its record relative to the rest of the world.
The top bank had raised the policy rate to 6.5 percent in February 2023, when GDP growth rate for the year was 7 percent and inflation had peaked at 6.7 percent. The rate did not seem too high the following year when growth accelerated to 8.2 percent and inflation moderated to 5.4 percent. However, the rate seemed unjustifiably high with growth projected to decelerate to 6.4 percent and inflation to moderate to 4.8 percent during the current year.
India’s inflation rate has moderated in comparison to other countries too. It was several times higher than those of the advanced economies (AE) or the global average prior to Inflation Targeting (IT). Currently it is close to the AE average and lower than the global average.
It would be erroneous to argue that an inflation rate of 4.8 percent would be inimical to growth, warranting continued tightening. No clear trade-off between growth and inflation has been established empirically at moderate levels of inflation. The trade-off is more evident at very low or very high levels of inflation. But an inflation rate of 4 percent, 4.5 percent, or 4.8 percent has little impact on growth.
A pertinent question to ask at this juncture, when the IT regime is in its 9th, and the RBI is in its 90th year of existence, is: how might IT, and RBI evolve, going forward?
Both warrant a fresh look.
After the initial success of IT, it was equally important to upgrade the necessary ingredients for a successful regime. These included a relevant and updated CPI basket; more accurate forecasts of inflation and growth to guide monetary policy; better measurement and management of the households’ inflationary expectations; and improvement in the transmission of monetary policy.
Disappointingly, most of these key ingredients have lagged: The RBI has been chasing an inflation target based on a dated price basket. It has often missed its forecasts by a large margin. The inflationary expectations of households have remained misaligned. And the transmission of monetary policy has not improved adequately.
An obvious way forward would be to address each of these key distortions to maintain the sanctity of the IT framework; as well as to minimize frictions with other constituents of the policy-making establishment. Some Suggestions are below.
Review Inflation Targeting
It would be prudent to conduct an independent review of IT to address the following questions: Is an inflation target of 4 percent still appropriate? Should India narrow down its inflation tolerance band of 2-6 percent? Should it move from targeting an inflation level within a band, to just targeting a narrower band of say 4-6 percent, with no explicit point target?
Revise CPI basket
This will help to better deliver the mandate of monetary policy. Other countries revise their baskets every 1-5 years, but India has not done so since 2011. This is despite the fact that in the interregnum, the per capita income has tripled and the shares of both agriculture and food in the GDP have declined substantially from their erstwhile levels. In view of such a transformation, its current weight of food in consumption is likely only 30-35 percent rather than 45.8 percent.
In fact, it would be sensible to commit to review and revise the IT framework and the CPI basket every 3-5 years.
Strengthen RBI’s technical expertise
The RBI’s technical expertise ought to be strengthened, especially its forecasting models; and the measurement and management of the inflationary expectations of households.
The RBI is often referred to as a full- menu central bank. Besides setting the monetary policy, it performs several other crucial tasks, such as, regulating the banks and parts of the NBFC segment; managing the debt of the Centre as well as of the states; and responding to the external conditions through the management of the exchange rate, foreign exchange reserves, macro prudential measures and capital flow measures. Each one of these functions matters for the health of the economy.
Yet, it is the setting of policy rates that attracts its maximum attention, especially since it adopted IT. Seemingly, the decision-making and engagement process around IT has partially crowded out its other functions.
RBI needs to strengthen all its functions to become the central bank of a ‘Viksit Bharat’. Among other things, the RBI ought to initiate a review of its supervision and regulatory frameworks, ensuring timely and gentler pre-emptive measures rather than reactive and excessive actions.
RBI has been a great institution and has evolved in keeping with the times. It needs to continue to evolve in accordance with the needs of a larger, faster-growing, a more internationally integrated, and a more complex economy.
