Finance Minister Nirmala Sitharaman has said that the inflation target of 4 per cent, with a band of 2 per cent to 6 per cent, is up for review as the current framework under which the country's interest rate is set is nearing the end of its five-year term.
The Reserve Bank of India's Monetary Policy Committee (MPC) is also completing its five years in March next year.
The new MPC framework agreed between the government and the Reserve Bank of India is up for a review of the inflation target and not the entire framework. But in the light of changed development, there is a need for a comprehensive review of the framework. The review actually should include liquidity management and use of various monetary tools like reverse repo rate, bank rate, cash reserve ratio (CRR) or exchange policy which influences liquidity in the system.
Of late, the inflation was rising and interest rates were stagnant, but liquidity was flowing into the system because of dollar inflows, which the RBI was absorbing (and releasing rupee resources). In a way, an appreciating rupee against the US dollar was helping in containing imported inflation. But such a policy has other implications for economy as exporters suffer and RBI's balance sheet also ends up holding foreign exchange reserves, which are low yielding.
The MPC review should take into account these variables, which impact the monetary policy.
In the last 5 years, inflation as measured by CPI fell from 5 per cent per cent in 2016, when the MPC was constituted, to below 2 per cent level in January 2019. However, it has been on the rise for over a year. In fact, inflation has been over 6 per cent for last few quarters. Last July, the CPI was recorded at a much higher 7 per cent. Part of the reason was pandemic and breakdown of supply chains. Inflation has now dropped in December and January to 4 per cent level.
There are some economists who are questioning the CPI benchmark itself. The reason being a higher weightage to food basket in CPI, which is almost half. Globally, CPI is used as an inflation targeting benchmark. They suggest mix of CPI and WPI as the new anchor for the MPC to fix the interest rates.
The inflation target could be tweaked to accommodate the government's higher borrowing plan of Rs 12 lakh crore in 2021-22. The government had borrowed Rs 12.80 lakh crore in 2020-21 due to the pandemic, which resulted in lower tax revenues and additional expenditure on healthcare and social spending.
The next 5-year inflation target is also very important in view of a long five-year fiscal consolidation path to 4.5 per cent fiscal deficit by 2025-26. Fiscal deficit has already skyrocketed to 9.5 per cent in 2020-21. The government has budgeted a fiscal deficit of 6.8 per cent of GDP in 2021-22. Clearly, the government is focusing on supporting economic recovery by deploying more money into capital expenditure plans.
In the last one year, the liquidity management by the RBI has seen the dilution of the MPC framework. Former RBI Governor Urjit Patel and former Deputy Governor Viral Acharya had raised the issue of surplus liquidity in the system, which dilutes the MPC framework. They reasoned that if MPC is the decision-making authority for setting interest rates, then the financial system should be in 'liquidity deficit' or in marginal surplus mode. But the RBI has kept the liquidity system at 'surplus mode'.
That decision of RBI actually made the policy repo rate, which the MPC decides, ineffective, while the reverse repo rate set by the RBI has become the effective rate for absorbing large surplus liquidity. Currently, RBI has continued its accommodative stance despite higher inflation.
There is another view that the inflation target of 4 per cent is too low for India. The US Federal Reserve is all set to keep interest rates near zero for a long period even if the inflation rises. This is the new approach US Federal Reserve is following by tracking average inflation.
In the Indian scenario, inflationary pressure could come from many areas. The deterioration in India's financials could result in a rating downgrade, which has the potential to trigger dollar outflows from the country. This could depress the currency value, which means imported inflation.
Rising oil prices are another big danger. The surplus liquidity, both domestic and global, will also result in inflationary pressure at some stage in future. It is already contributing to asset prices. While the stock markets are already on fire, commodity prices, especially steel, cement, etc, are also facing price pressures.