Finance Minister Nirmala Sitharaman has said that the consumer price index (CPI) or retail inflation target of 4 per cent with a band of 2 per cent to 6 per cent is up for review as the term of the first five years of MPC ends in March this year. The likely options before the government are continuing with the existing 4 per cent target, changing the target upward, or changing the benchmark itself from CPI to core inflation or wholesale price index (WPI). But there are more aspects than inflation band or benchmark, which need policymakers' attention.
RBI's Inflation Forecasting Model
RBI has been behind the curve in projecting inflation and needs a better inflation forecasting model. Accurate inflation forecasting is very important for monetary policy formulation as interest rates are fixed based on the inflationary scenario. In the last year, the RBI underestimated retail inflation. Covid outbreak and lockdown contributed to supply-side shocks, but the record during pre-covid period is also not very encouraging. The inflation projected by RBI for 2018 and 2019 shows that the Central Bank had overestimated inflation for two years.
RBI's Liquidity Measures Outside MPC
The central bank has taken a number of liquidity measures outside the MPC, which means a dilution of the MPC's role. The new arrangement agreed between the government and the RBI means a review of the inflation target and not the entire framework. But the review should include RBI's liquidity management and the use of various monetary tools like reverse repo, bank rate, CRR, or exchange rate policy which influence liquidity in the system, thereby diluting the role of six-member MPC. The recent post-Covid liquidity measures taken by the RBI have seen dilution of the MPC framework.
Support From Fiscal Policy
The MPC also needs support from fiscal policy. The fiscal consolidation path is wide off the mark. The past 10-year track record of fiscal consolidation isn't encouraging. It may be remembered that the government had to give fiscal stimulus post the global financial crisis in 2008, which pushed the fiscal deficit to 6.2 per cent in 2008-09 and 6.6 per cent in 2009-10. Over the last decade, the fiscal deficit numbers did come down from to a low of 3.4 per cent in 2018-19 but failed to go down to an acceptable 3 per cent. This was despite economic oil advantage (falling oil prices). Post pandemic, there is yet another excuse for not meeting the target. The new fiscal consolidation path from 9.5 per cent of GDP in the pandemic year 2020-21 to 4.5 per cent by the end of fifth year clearly sets a five-year-long fiscal consolidation path. Should RBI trust the government's promise to return to fiscal consolidation path of 4.5 per cent by 2025-26?
RBI's dual role as debt manager
There is a need for a new institutional framework for managing government debt just as the MPC was constituted for better decision making. Currently, the RBI's role as a debt manager for government is in conflict with the monetary policy. As a debt manager, the RBI tries its best to raise the government debt at the lowest possible rates whereas, for monetary policy, it has to be impartial and vote for hiking interest rates if there is a good case. Post-pandemic, the RBI is quite vocal and open in maintaining and reducing bond yields to below 6 per cent and help the government in borrowing from the market. It is time now for creating a separate debt management department outside the RBI.
Interest rate transmission
Despite reduction in policy rates by over 250 basis points in the last two years, the lending rates fell by little over 100 basis points. Most of the bank deposits are fixed in nature, which comes in the way of reducing the lending rate as the cost of fund is higher. In addition, the bank also competes with postal savings rates where the interest rates are higher. The banks are notorious in not transferring the benefit to borrowers, which leads to such a mismatch. A lot needs to be done in the area of interest rate transmission.
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