Monetary policy is governed by the central bank of the country, that is, Reserve Bank of India (RBI) in case of India. All over the world, policy rates of interest are important instruments in monetary policy operations. RBI announces its monetary policy, which includes policy rates of interest such as, bank rate, repo rate and reverse repo rate.

What determines policy rates of interest?

The RBI announces the policy rates of interest, depending upon its assessment of inflation and the demand and supply of credit in the economy. RBI’s main objective in this case is curbing inflation from breaching its limits. Before 2017, the RBI was using Wholesale Price Index (WPI) as anchor to target inflation. However, in 2014, when Raghuram Rajan was Governor, RBI, under the chairmanship of the then RBI Deputy Governor Urjit Patel a committee recommended use of Consumer Price Index (CPI) rather than WPI for inflation targeting. Notably, CPI has a greater weight of 46% for food products compared to only 30% (including manufactured food products) in WPI. In the initial years of the NDA government, food inflation used to be much higher, and therefore, the repo rate based on CPI inflation targeting continued to be high despite cooling down of WPI-based inflation. However, in the later years of the NDA government, even CPI had fallen significantly, and remained low, at less than 3%, repo rate remained at hardly 4%, over a long period between May 2020 and May 2022.

Role of Monetary Policy Committee (MPC)

On 27th June 2016, MPC first came into existence. The MPC consists of 6 members, out of which three members are the officers of RBI and three are external members nominated by the Government of India. The Governor of the RBI is the Chairperson ex-officio of the committee. MPC announces the monetary policy for the country. Decisions are taken by majority where the RBI Governor reserves the casting vote in case of a tie. The current mandate of the committee is to maintain 4% annual inflation until 31 March 2026 with an upper tolerance of 6% and a lower tolerance of 2%.

But before Covid-19, despite a continuously low CPI inflation, the RBI Governor and later even the MPC continued to 'undermine' low and falling CPI inflation, based on their inflationary expectation and refused to reduce the repo rate in the name of inflation targeting based on their 'expectations about inflation', even when in the every next review, their stance continued to be proven wrong.

In the past few years there has been a huge difference between CPI and WPI, while CPI remained too high as compared to WPI. In the last financial year, though CPI has been high, WPI has remained in the negative zone. But based on the mandate for MPC, RBI continued with CPI anchored inflation targeting, MPC has been keeping the repo rate at the same level at 6.5%, since January 2023, despite a much lower or even negative WPI.

It is no secret that policy rates of interest, especially repo rate is crucial for growth in the economy. We understand that low rates of interest encourage investment and purchase of consumer durables and houses. If the rate of interest keeps high, those with surplus funds will try to hold interest bearing bonds and not invest in real assets. Also, those who need to borrow for investment and purchase of consumer durables and houses, would be less inclined to do so. Therefore, in the name of curbing inflation, actually growth would be curbed.

CPI based inflation targeting being questioned

Many economists have now started questioning the CPI based inflation targeting. Though it is important to keep inflation under check, to make sure that masses do not reel under inflation, as it hits poor the most, questions are being raised about the sanctity of CPI or even WPI, as the basis of inflation targeting. Those who say so, base their case on the following arguments:

Firstly, the idea of inflation targeting is an imported idea from the west. We understand that the objectives of monetary policy in a developing country like India, include growth, employment and uplifting of the poor and downtrodden. No monetary policy is complete without addressing these objectives. Any monetary policy, which is devoid of these concerns is nothing but lopsided.

Secondly, if we see that there have been many occasions, when despite religiously following CPI anchored inflation targeting by MPC, inflation not only was not contained, rather it breached the 6% mark also on many occasions. This proves that CPI is not the perfect anchor as compared to WPI. We understand that CPI is greatly influenced by food prices. Food prices move more due to seasonal factors and not generally by fundamentals of the economy. There are several occasions when onion and tomato prices have been major drivers of inflation. In any case such cases are dealt with by direct measures and not indirect ones like monetary policy. Therefore, if we try to target inflation based on seasonal factors and decide policy rates of interest accordingly, we are bound to make mistakes.

Thirdly, though CPI alone doesn't seem to be an appropriate anchor for inflation targeting, WPI too is not a proper anchor either. Therefore, some people suggest that there should be a combination or may be a blend of these two indices, CPI and WPI.

Is CPI based inflation targeting, An IMF Agenda?

While developing countries are debating about inflation targeting itself, the IMF has put their weight in favour, not only about the imperative of inflation targeting, but also using CPI as anchor for inflation targeting, for developing countries. This is something that needs to be objected.

Firstly, we need to decide whether only inflation targeting will work or we have to think about other objectives of monetary policy also.
Secondly, we have to see whether WPI or a blend of CPI and WPI or some other indices should be used for inflation targeting.

Danger of Deflation

Though, in the post MPC and CPI anchoring era, when CPI inflation rate was low, and therefore, rate of interest has been generally gradually declining, growth obviously did not get hampered. However, in the post Covid period due to reasons not related to fundamentals of the Indian economy, CPI stayed high (primarily due to disruption in global value chains, soaring food prices due to global shortage of food and increase in fuel prices), which led MPC to raise policy rates of interest. However, between 2021-22 and 2023-24, WPI stayed much lower than CPI, and ultimately entered the negative zone. But since MPC was using CPI as an anchor for inflation targeting, higher interest rates started impacting growth by causing WPI travelling in negative zone. This caused a situation of deflation in the country. This situation is not very auspicious for the economy.

Therefore, it is the time to pause and think about tweaking the anchor for inflation targeting. Must remember, economic policies, whether fiscal or monetary, cannot move in a straight line. We must realise the complexities of the real world before deciding on economic policies.

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