Committee
formed by: Reserve Bank of
India
Committee’s
Official Name: Expert Committee
to Revise and Strengthen the Monetary Policy Framework
Chairman: Dr. Urjit Patel, Dy. Governor of RBI.
September 5, 2013 was
the day when Dr. Raghuram Rajan took charge as the 23rd Governor of
the Reserve Bank of India succeeding Mr. Duvvuri Subbarao. As soon as he took
over, he had a mammoth task – strengthening the monetary policy framework so as
to stabilize the Indian economy which had inflation already surging to the levels
of 11% before he assumed the office.
So how did Rajan
answer? Abraham Lincoln said that, “If I had 10 days to cut a tree, I would
spend 9 days sharpening the blade of my axe.” Rajan seems to have had taken a
similar route by doing his favorite thing – form a committee to find out the
real problem and attack it with a complete strategy.
Result: A committee headed by the then Dy. Governor of the RBI was
appointed and was named ‘Urjit Patel
Committee’ (Well this was not the only committee; our governor seems to be
a lover of committees which led him form a few which were led by Nachiket Mor,
Bimal Jalan etc. to address issues of Financial Inclusion, Bank Licenses
respectively)
Let us however focus
on our topic of interest – Why, in 2013, did Rajan take the route of keeping
inflation under control to stabilize the Indian economy?
Have a look at what
options the Urjit Patel Committee observed to to strengthen the framework,
Location: RBI Headquarters, Mumbai
(Raghuram Rajan who
had taken a leave from his teaching profession at the University of Chicago Booth
School of Business is now chairing the meeting as the Governor of RBI)
Time: It is the year 2013 when this discussion is being held
Conference starts….
RaRa: Urjit bhai!! Have you completed the assignment?
UrPa: Yes sir, we have completed our group assignment
RaRa: Cool! Kya socha hai??
Kaise aage badhe apni India ki economy strong banaane ke liye? (What has
your committee thought Urjit? How should we move forward on making our Indian
economy strong?)
UrPa: Sir….
RaRa: Sir matt bolo bhai!!
I am not a professor right now….
UrPa: We have found out three main anchors to frame monetary policy
1. Focus on Exchange Rate
2. Focus on Monetary Aggregates (GDP, IIP,
Exchange rate, inflation)
3. Focus on Inflation
RaRa: Apun log toh abhi
Monetary Aggregates ke basis pe monetary policy bana rele hai na!! (We were
till now framing our monetary policy on the basis of Multiple Indicators,
right?)
UrPa: Absolutely sir!!
RaRa: Again you are designating me as ‘Sir’!!
UrPa: Sorry sir!!
RaRa: Urjit!!! One more time you call me that and I will give you D
Grade in your assignment..
UrPa: Ok then, I will address you as ‘Raghu’
RaRa: Sounds cool!!
UrPa: Yes, Raghu!! So now let me take you to the pros and cons of
each of these strategies
1. Our
dear Monetary Aggregates Anchor….
UrPa:
Raghu, right now we go
by this route and under this method we need to gather the following data to frame
our monetary policy,
1. Index of industrial production (IIP), Consumer
confidence
2. Professional forecasts about GDP, inflation,
unemployment
3. Inflation data: WPI minus food, fuel.
After this, the
governor will design the monetary policy (mainly repo rate), with following
objectives/focuses:
1. Increase employment
2. Increase GDP
3. Stabilize inflation
4. Stabilize exchange rate
RaRa: What!!!?? You know what Urjit, this is not
how you control a developing economy!! This is a many-to-many function that I
learnt in mathematics during my high school before I joined IIT; this doesn’t
work for framing a monetary policy for a country like India…. Have you found
out the limitations of this method?
UrPa: Yes Raghu, we have enlisted some of the
limitations of this technique,
· First of all, Monetary
Aggregates has no nominal anchor. Under this, we have IIP data, GDP data,
consumer confidence, WPI, exchange rate and many other aspects to concentrate
upon in order to frame our monetary policy!! Till now we never knew where to
focus upon… Therefore it was on a larger scale ineffective
· Since this strategy
does not have a particular target, RBI has to continuously change its monetary
policy to take care of different groups in the country viz.,
Therefore, the panel
recommends to dump this idea to focus on monetary aggregates.
UrPa: Raghu, if we adapt this method, you will have a tough time
with importers and exporters
RaRa: Urjit, I think you are aware that in your assignment, you have
marks for proper explanation as well!!!
UrPa: Yaar, main abhi bolne
hee waalaa tha!! (I was about to come to this point!!)
RaRa: Go on Urjit…
UrPa(To RaRa): If RBI adopts this strategy/method to frame
monetary policy,
·
Out of the blue, you
will first decide an ideal target exchange rate say 1$=Rs.70
·
Then you’ll try to
amend monetary policy to control rupee supply in the market.
But, in our economy where
we deal with both imports and exports, in order to take care of our Current
Account, you will have to continuously change the monetary policy to keep the
rupee stable.
We are moving towards
increased globalization, where we have to deal with foreign economies; an
effect on the foreign economies will directly affect the exchange rate which
will invariably put us under pressure for changing the monetary policies. Thus
we will be continuously exposed and become vulnerable to global jeopardizes and
then we will have a tough time answering Arnab Goswami for our continuously
changing policies.
RaRa (checking UrPa’s concepts): But, our economy is highly dependent on oil
imports and the same contributes largely to the import bill. If I keep the
exchange rate higher (make Rupee stronger against the USD), won’t it benefit on
the account deficit?
UrPa: Raghu, you’re right!! But we also have exporters in our
economy. If we make the rupee stronger, it will directly have a hit on the
revenues of exporters => their business will be hit => low export
incentives => lower revenues from exports => no significant effect on the
CAD => purpose not solved => common man unhappy => take a firing from
government, newspapers and Arnab Goswami
This method,
· Will not be able to
control the food inflation within the country and this step will directly be
the one which only takes care of imports and exports i.e. international trade
· Works well for a small
economies as their population is small.
· Serves the purpose for
export-oriented countries like China, that can keep their exchange rates lower
to get competitiveness in the global market.
· Also, if RBI’s
statistical projections go wrong, we’ll have to make new adjustments in the exchange rates to arrive to a balance again
All this will lead to à Government will not
get the real scenario of where the economy is moving => Steps will lead to
high inflation => Real interest rates become negative; Aam Aadmi will start investing more in safe foreign havens => Imports increased => payments have to be made
in Dollars => Continuous imbalance in Exchange Rates => RBI will have hard
time controlling the imbalance => Mixed speculations about Indian economy in
the global market => wild forex trading => RBI screwed….
RaRa: Control Urjit!! Control!! We got the point….Well
done!!
UrPa (Just recovering
from a World War kinda mood): Thank you Raghu!!
RaRa: So now as per your committee research, the
Monetary Aggregates and Exchange Rate anchors are not the correct ones. So the
only option left out is targeting Inflation. Right??
3.
Inflation
RaRa: Urjit, before you begin on this, I would like to interfere and
like to know how you will move forward explaining this because it would be no
point if you have not got your basics updated ….
UrPa: Sure Raghu, please raise your concern!!
RaRa: India has been considering Wholesale Price Index (WPI) for
measuring inflation. I was stunned when even Arvind (Arvind Subramanian) was
supporting this. This is actually not the way. WPI does not consider the direct
effect on end consumer. It is more oriented towards the effect on the inflation
that companies face due to increase in price. The actual parameter that serves
this is Consumer Price Index (CPI). We need to now change our way of measuring
inflation. Even the leading economies in the world are taking this route as a
measure of inflation!!
UrPa: Raghu!! These are exactly the points that we have focused upon
while framing our report and doing our research. We have here discussed
targeting inflation keeping CPI as the measure of Inflation. Also, I would like
to add that you had discussed the same in the report of Financial Sector Reforms that was chaired by you back
in 2009.
RaRa: Yeah!! I remember that
UrPa: Raghu,
would you also like to throw a light on this and explain the base on this
because we all members present here enjoy the way you explain…
RaRa: Ok, Task
Accepted!! So all members present here, please listen how this works,
In this strategy, we
will decide a Nominal Anchor – specifically CPI, to monitor inflation. Then
we’ll fix an inflation-target (which I want to know if Urjit and his committee
have derived or not) and adjust the monetary policy so that inflation remains
within that range.
· Understand that RBI
has the supreme power in framing the monetary policy and once we will set our
aim on controlling inflation in a certain range, nobody (not even the govt.)
will be able to influence us on what to do. But, being concerned for aam aadmi,we will ensure that we take
needful steps and they are also not affected. It will be my task of explaining
and winning the confidence of India on our team’s stance!!
· It will be easy to
track progress as the CPI data is released after every 12 days and we’ll have a
timely check if we have framed our policy correct
· Also, aam aadmi will be able to understand
what we at RBI are doing and whether it yielding result or not…
(Now, Harsh Pathak is a guest attendant at this RBI meeting and
is feeling very much enthusiastic on this discussion and explanation given by
Mr. Raghuram Rajan and wants to know more from the newly appointed governor
regarding this highly sought method of controlling inflation)
HP (to RaRa): Sir…
RaRa: Yes Harsh, tell me. You have been sitting patiently
for a long time now listening to our discussion. Please feel free to ask your
doubt.
HP (already totally
overwhelmed by RaRa’s invite): Thank you sir. I wanted to know more regarding why we should
concentrate more on CPI because even this has many problems…
RaRa: Ok, like?
HP: The CPI has more than 50% weightage on
components that are related to food and fuel. And our economy, having a gigantic
size of black market affects the food inflation on a large extent and then we
have the Agricultural Sector which is the largest economy activity in India
highly dependent on monsoon. We do not have any control on these factors, but
only make predictions. How about that??
RaRa: This is a good question!! Look, in line with
what Urjit explained,
·
If we focus on controlling
the Exchange Rate, we would be exposed to black market movement and the
climatic conditions throughout the global economies which would be even worse
and we would have to, every now and then, adjust according to the global
movements, which would be even worse.
·
In multiple aggregators, we absolutely have no idea where we would be focusing and that is
even worst. Hence, it would be
better if we concentrate on CPI itself because like you yourself mentioned, it
has >50% weightage on food and fuel components, with the help of which we
would be able to track the effect of the same on end consumers and that will
help us control the policy better
HP: But sir, don’t we have CPI for Rural and
Urban separately? Where would RBI target? Rural or Urban?
RaRa: Urjit, would you like to interfere?
UrPa: Yes, so Harsh… as per our report’s findings,
we would take into account both of them which would be released as a data
called ‘CPI combined’. We will control that
HP: But then don’t you think that the results of
the policy that you frame will take several months to start showing up?
Because, the data will be released every 12 days while the results take several
months to show up!!
RaRa: Yes, but then any method you choose, it
takes time to show results. Here, as CPI directly shows the effect of policy on
end consumer, and this data being released every 12 days, we can plan our
strategies on policy and keep a perfect track of the consumer reaction and thus
we will have control over what will show up after several months – because, We
Will Have a TARGET
HP: Ok sir, but won’t this need a proper flow of
information across government statistical departments which is very inefficient
today?
RaRa: I will take forward your word and we will
have a joint discussion with the Prime Minister regarding this!!
HP (again overwhelmed
and with dreamy eyes): Sure sir!!
RaRa: Cooool!! Let me however explain further why
we need to target inflation through CPI
In the past 3-4 years after the Great recession, nearly all the
developing countries in the world have been successful in bring their inflation
down from extremely high levels. Only we are such a country whose inflation has soared to extreme levels. Because
of this we have reached this position,
Higher inflation => real interest rates
decreased => makes people invest more in safe foreign havens than deposit in
banks=> increase in CAD => rupee weaken => expensive fuel because of
expensive import bill => expensive
manufactured products => even more inflation => TARGET not met
Our inflation has grown so much that we have landed in a position where
our banks are giving out negative ‘real interest’. So, if Indians deposit their
money in banks, the future value of a common man’s liquid cash decreases. We
have been recently out of the real estate and housing sector bubble and this
may not be much favorable for an investor. Hence, people tend to invest more in
gold which again contributes to increase in the import bill which lands up in
the flow as stated above which leads to even more inflation.
I however have a very arduous task of cleaning up the balance sheet of
our banks and it would be tough for me to accomplish this if a common man’s
outlook on banks remains negative. Because, when people invest money in safe foreign havens instead of
putting it in bank=> businessmen get less loans => less expansion =>
low employment growth (if not decrease in employement) => less growth in GDP
=> even worse outlook in the eyes of global economies => again the tough
cycle
So, my point is that
if we want to make our monetary policy framework strong and in turn to make our
economy strong, we should target on controlling inflation by maintain CPI as
desired.
HP: Sir, right now I am so much satisfied with your explanation
that I would, after this meeting, request you to be my guide on understanding
our Indian economy as well as the global economy. I however, at this moment, am
eager to know what target are we planning to accomplish in this line of
controlling inflation through CPI numbers….
RaRa: Urjit, please take over from here…..we want to know the
findings of your committee in this line
UrPa: Sure Raghu!! So, as per our findings and research, we have
decided on a range for containing CPI. We should target CPI at 4% and then
maintain it in the range of +/- 2% and hence the range is 2-6%
HP: Sir, why have you defined a range and not a specific and
precise number as a target. Like you target only and only 4%. Why this +/-2%
range?
UrPa: Harsh, CPI takes into account the inflation number of an
entire nation and it is measured on the basis of several parameters. This means
in oreder to target a specific and precise CPI number, you will have to fix a
specific and precise targets for each and every component of the entire nation,
and then it was you yourself who said that we are exposed to climatic
jeopardizes, so how can we achieve this?? Thus, we will need a room to
accommodate such shocks….
RaRa: Cool Urjit!! Cool!!
HP: Agreed sir…
UrPa: Don’t worry guys, I’m not getting over-excited. This is my
normal way of talking. (Smiles with wide face). So, hence we have defined a
range for containing inflation i.e. +/- 2%
HP: But sir, why only +/- 2% and not something else?
UrPa: This is because,
·
Intense research has
shown that a minimum of 2% inflation is desirable for any growing economy
·
An inflation means
prices are growing steadily. This gives incentives to businesses to expand
=> more employement => rise in economic activity => increase in GDP
with low inflation
·
Research has also
shown that inflation beyond 6.6% is not desirable. This negatively affects the
economic activities because if inflation goes beyond this and if the per capita
Purchasing Power does not grow equivalently, this will lead to negative
implications on the economy and is not good for the common man’s growth.
HP: Ohhh…. I understood your point. I was just about to ask if we
can have negative inflation target. But now I understand that this is not good
for growing business sentiment. Any other factor apart from business??
UrPa: You have been going so much conceptually till now…How did you
miss out on understanding this?? And I am surprised that though being a
Gujarati, you think apart from business
HP (confused and with a small grin): Yesss…
UrPa: Don’t worry, it is good to be sometimes confused over things!!
RaRa: Looks inquisitively at Urjit
UrPa (seeing Rajan’s reaction): No, never be confused !!!!
(The whole committee
has a loud laugh)
UrPa: Yes, there are effects of negative inflation apart from only
that on business. Listen,
Like, if prices of everything fall, then
customs duty, VAT, excise duty, service tax- their collection will also
decrease. Then government has less money to spend on education, healthcare,
social sector, defense, law and order which leads to consequences like poverty,
crime etc.
HP: Ohhhh….quite interesting!!
RaRa: Urjit, any real examples in this line that you found out as an
explanation?
UrPa: Yes, we have live examples of Chile and Czech Republic let me
give you all an example of Chile
·
Chile was facing CPI
inflation as high as 29% during the late 90’s
·
But in the early
2000s, the RBI of Chile made the target “3% CPI (With +/-1% band)”=2-4% CPI
·
From the following
graph, one can see Chile’s RBI has successfully managed to contain inflation
within that 2-4% level.
RaRa: How do you recommend to move forward on this?
UrPa: Sir, as per our committee discussion, we have come up with the
following timeline to contain CPI numbers,
In short, 0/12/24
(months) =>10/8/6 (CPI)
RaRa: So you say that we need to frame our policy to achieve these
numbers?
UrPa: Yes Raghu. Absolutely!!
HP: Sir, what do you intend when you say on framing a proper
policy?
UrPa: Repo rate under Liquidity Adjustment
Facility (LAF) is our policy rate.
·
Reverse repo(RR) = Repo – minus 1%
·
MSF=Repo +plus 1%
RBI should not change this +/- 1%
spread between RR-Repo-MSF. (unless in extreme situation) because unpredictable
policy making will be not good for banking sector’s own business plans and
tactical projections
HP: And sir, how will this lead to our
target of containing inflation?
UrPa: Look,
first you need to be clear that when Repo rate is lower than CPI, That’s why its
ineffective. This is what has been happening till now and that’s why we
were having very ineffective handling of Indian economy and none of the
monetary policy frameworks worked.
Therefore, to fight
inflation repo rate must be increased. We recommend that Repo rate should be
increased so much that its higher than CPI. In other words, difference between
Policy rate (Repo rate) and CPI should be “positive”, Only then Policy rate can
fight inflation.
Now let’s see how this
performs,
Banks borrow less from RBI => Banks will
increase their loan interest rates (to maintain their profit margin => Less
business expansion => Less new jobs created => Less income => Less demand
=> Reduction in prices of goods and services to attract and retain
customers.=> Inflation reduced
HP: Now, I’m confused. I was informed here that
we do not want to create a scenario where employment falls and business
sentiment goes down because of less borrowing. Also, our GDP numbers will take
a hit in this scenario.
RaRa: Harsh, I think Urjit has a legit point here.
When a child goes on a wrong track, it is necessary to take extreme steps to
bring her/him in discipline. Our economy has also totally gone out of control
and we will have to take steps to bring it in discipline. We want to make it
sturdy and strong on way ahead and we want to make it globally the front
runner. Hence we will have to take such steps
UrPa (Now taking a
sigh of relief after hearing the positive note from the governor): Yes!! Indeed the reason to take such a
step!!
(The whole RBI board gives consensus to this recommendation…)
RaRa: Cooool!!! So Harsh how did you find our job
@RBI??
HP: Sir, you all rock!!! What a discussion!!
RaRa: Haha….that’s why they call me the ‘Bond of
Market’. I Do What I Do!!
HP: I can realize that very well sir!!
RaRa: Which university are you from by the way
Harsh?
HP: Sir, I am from MISB Bocconi and I am an
aspiring MBA graduate with a focus on Finance as a specialization
RaRa: Cooool!!! Now that we have come up with a
consensus on the way forward, let’s rock ‘n’ roll!!
- Harsh Pathak, Student at MISB Bocconi - Bocconi University
