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India: RBI moves toward monetary policy reform

January 21, 2014

On 21 January a committee established by RBI Governor Raghuram Rajan submitted the Urjit Patel Committee Report, in which presented recommendations for reforming and strengthening the Reserve Bank of India's (RBI) monetary policy framework. The reform, if carried out, would be the Central Bank's biggest overhaul in the last 15 years. In the previous overhaul, monetary authorities moved away from money supply targeting and established the repurchase rate as the main monetary policy rate.

Most analysts welcome the recommendations and agree that the shift would bring the RBI's practices in line with other central banks. According to the committee, the Reserve Bank of India should formally target the consumer price index (CPI) instead of the wholesale price index (WPI) as the anchor for monetary policy. The committee also agrees that the Bank should establish a long-term inflation target of 4.0% with a plus/minus 2.0% tolerance margin. The expert committee argues that the CPI is a better indicator for the cost of living and for inflation expectations, as the WPI has failed to capture movements in the cost of services, which is a sector that represents around two-thirds of the Indian economy. The committee also recommended a transitional phase during which the Bank could move toward the aforementioned inflation target zone, as consumer prices remain elevated. Moreover, the Central Bank should create a five-member Monetary Policy Committee (MPC) that would be in charge of monetary policy. The MPC would consist of the governor, deputy governor and executive governor, plus two external members who would be elected by the RBI. Currently, monetary policy decisions are the preserve of the RBI governor. In addition, the report stated that the Central Bank should publish the minutes of the MPC's proceedings and release them with a lag of no more than two weeks.

The Committee is also calling for institutional support. According to the report, the general government must ensure that the fiscal deficit decreases to 3.0% of GDP by fiscal year 2017/2018 (estimate for FY 2013/2014: 5.0% of GDP) and it has to commit to eliminating other impediments to monetary policy transmission such as administered prices, wages and interest rates. The report concluded that the Central Bank should continue to use the existing operative policy framework during the transition phase. It specified that the repurchase rate should continue to be the only policy rate. When the RBI is in a position to adopt the 4.0% inflation target, the monetary policy rate voted for by the MPC will be a target rate of the money market. Most analysts agree that during the transition period, interest rates will be high, as inflation is expected to remain elevated.

Author:, Senior Economist

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