RBI Monetary Policy Committee, Jayanth R Varma
Last month, the RBI retained its inflation projection for 2022-23 at 6.7% amid geopolitical concerns triggered by the Russia-Ukraine war, and expected inflation to be under control from January.

Inflation? Growth? There's much ado over ideal monetary policy target

Is inflation targeting the right goal of monetary policy? Or should it target growth or financial stability? Considerable heat is generated on these questions. This debate has as much operational significance for the real world as a debate on the comparative merits of Lata Mangeshkar and Asha Bhosle or of Virat Kohli and MS Dhoni.

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India will continue with containing inflation at 4%, within a range of two percentage points above and below that rate, as the target of monetary policy. Is inflation targeting the right goal of monetary policy? Or should monetary policy target growth? Or should it prioritise financial stability over everything else? Considerable heat is generated on these questions in those rarefied circles where debating such things arouses and consumes passion. This debate has as much operational significance for the real world as a debate on the comparative merits of Lata Mangeshkar and Asha Bhosle or of Virat Kohli and MS Dhoni.

This is simply because monetary policy, as conducted by the Reserve Bank of India, has evolved a lot from setting the repo rate (the rate at which banks can borrow from the RBI for a single day), the reverse repo rate (the rate of interest the RBI would pay banks for making overnight deposits with the central bank) and the marginal standing facility rate (the rate at which banks can borrow additional funds from the central bank but at a rate higher than the repo rate) — the so-called policy rates. These rates are set once in two months, at a meeting of the Monetary Policy Committee of the RBI, which has six members, comprising the chair, the RBI Governor, two other RBI nominees and three external members, mostly professional economists.

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A rule proposed by economist Jan Tinbergen in the 1950s holds that for every policy objective, you need a separate policy instrument. By that logic, using the rate of interest to hold down inflation and to propel growth is a no-no. Nevertheless, the US Fed is officially charged with holding inflation down and employment up. Nor has this prevented economists from proposing the nominal growth rate of the economy, which is roughly the sum of the real growth rate and the rate of inflation, as the ideal target of monetary policy.

Then, there is the famous central banker’s trilemma. It holds that it is not possible to have an independent monetary policy, free movement of cross-border capital and control over the exchange rate, all at once. The fortunate fact is that central banks do have many instruments at their disposal, besides setting policy rates.

The RBI buys and sells dollars to control the rupee’s exchange rate. This, of course, has a bearing on interest rates. When the RBI buys up dollars, so that there is no oversupply in the market to reduce its price in terms of rupees, that is, to prevent the strengthening of the rupee beyond what the RBI considers to be reasonable, the RBI pays for those dollars with rupees, increasing the supply of rupees. This could be inflationary, so the RBI mops up this creation of liquidity by selling bonds to banks. When the supply of bonds increases, their price drops and the yield goes up.

A bond offers a periodic return as a finite amount, say, Rs 100 on a bond with a face value of ₹1,000, and that amount, called Coupon, remains constant and the price of the bond goes above or below the face value, depending on how bond traders expect interest rates to move. When the price goes up, the yield goes down and when the price goes down, the yield goes up.

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We have already seen two instruments the RBI deploys, in addition to setting policy rates: buying dollars to prevent over-appreciation of the rupee and selling dollars to prevent over-depreciation; and open market operations, buying and selling of bonds, to change the level of liquidity in the system.

The RBI has added yet another tool to its armoury: Operation Twist. This consists of selling short-term bonds and, at the same time, buying up long-term bonds. An increased supply of short-term paper would depress their prices and put upward pressure on short-term interest rates. When long-term paper is sucked out, their prices would rise, lowering long-term yield. The yield curve — the plotting of yields against bond tenor, as it progresses from short-term to long-term — gets twisted, in the process.

Then, there are specific kinds of open market operations. Term repos, long-term repo operations, targeted long-term repo operations. These things sound complex, but are simple enough. A repo is sale of bonds with an obligation to repurchase them at a price slightly higher than the sale price, the difference in prices working out as interest for the period. The repo in the RBI’s repo rate is overnight. Banks can obtain funds from the RBI by selling bonds to the RBI, receiving money in return, with the commitment to buy those bonds back the next day at a price that is higher by the amount required by the repo rate. Term repos are for longer periods. Long-term repos are for extended periods. Long-term repo operations are called LTROs. Some LTROs make funds available for targeted use by the banks, say, to invest in paper issued by non-banking finance companies. These are called Targeted LTROs of TLTROs.

If the RBI wants to, it can turn on the tap at will, and suck out liquidity at will, as well, pretty much blunting the determinant edge of policy rates.

Given all this, it is pretty much immaterial what is officially deemed the monetary policy goal: inflation, growth, exchange rate, or financial stability. Inflation itself can be measured in various ways: by the consumer price index, by core inflation, that is, the consumer price index without its volatile elements of food and fuel, by the wholesale price index, the producer price index or some other index.

Inflation has to be kept in check, undoubtedly. But growth and employment matter, vitally. On occasion, exchange rate stability might warrant a hike in interest rates. Financial stability might warrant interest rate action and capital controls. The RBI is fully equipped to pursue all these goals, with the range of tools in its arsenal. It needs to be careful to avoid being called a currency manipulator, that is all. That would fetch punitive action by foreign governments, the US in particular.

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This being the case, the choice of the monetary policy variable is much ado about nothing. The actual conduct of monetary policy can pursue many goals, the length of the rope the RBI has to manoeuvre alone being conditioned by the rate of inflation the monetary policy goal sets.

In the modern world of cross-border flows of capital worth trillions of dollars each day, fiscal policy, capital market regulation and monetary policy must act in tandem to maintain financial stability. Central bank independence and autonomy of the capital markets regulator are convenient pieces of fiction to help the government and the regulators take decisions that could be politically unpalatable.

Regulators must regulate with integrity and competence. At the same time, they should be accountable to the democratic polity, rather than being free to fly on technocratic wings. In the real world, there is such a thing as regulatory capture. Regulators that do not answer to the people can subserve the interests of business with clout.

Therefore, regulators must be made statutorily accountable to a committee of Parliament, before which they must testify every quarter. This is the reform that matters, not the mumbo-jumbo over the ideal monetary policy target.

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