Urijit report: Will it sharpen power tiff between FM & RBI?

R JagannathanFirstpost.com

The report of the Urjit Patel committee, set up by Reserve Bank of India (RBI) Governor Raghuram Rajan last September, is likely to sharpen the power struggle between the finance ministry and the central bank.

The nine-member committee, tasked with the idea of evolving a monetary policy framework for the RBI, has suggested that the bank should target four percent retail inflation based on the consumer price index (CPI) in order to douse inflationary expectations. If this report is adopted by the Governor, one can kiss goodbye to any ideas about a quick drop in interest rates in 2014 as retail inflation currently is just under 10 percent – and significant cost pass-throughs in fuel (diesel, gas, power) and fertiliser are yet to happen.

The key recommendations of the Patel panel are the following: monetary policy will be set by a Monetary Policy Committee (MPC) and not the RBI Governor alone; this committee will decide rates by majority vote with no member having the right to abstain; inflation, rather than a mix-of growth-and-inflation, will be the RBI's main focus; getting the CPI-based inflation rate to 4 percent (within a band of +/- 2 percent) will be the medium term inflation target; CPI inflation will be brought down to 8 percent in 12 months and 6 percent in 24 months before the 4 percent target is finally accepted as the over-arching monetary policy goal.

What if the RBI fails to achieve these goals? The committee suggests that if the CPI band is missed for three quarters in a row, the MPC will have to explain in writing why it missed the bus, with each member of the MPC giving his or her own explanation if there is no unanimity.

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Any adoption of the 4 percent CPI target means that over the next three years, the RBI will be an inflation hawk. If food inflation remains, say, at 10 percent annually over three years, it will need negative inflation in the non-food sector to meet the target. The RBI is essentially targeting gentle deflation in manufacturing and services - something tough to imagine.

These recommendations are likely to make relations between North Block and Mint Street testier as growth versus inflation tensions play out in the public arena.

It is worth recalling that the spat between Finance Minister P Chidambaram and the previous RBI Governor, Duvvuri Subbarao, started when Subbarao failed to oblige him with a rate cut in October 2012 - after Chidambaram had indicated a fiscal consolidation roadmap. The disagreement was precisely over the growth-inflation tradeoff. Chidambaram went into a sulk and said that growth was as much of a challenge as inflation, and if necessary he will "walk alone."

In the draft Indian Financial Code suggested by the Justice BN Srikrishna committee last year, a key point of difference with what Urjit Patel has now recommended is that the inflation target would be set by the government in consultation with the RBI. The RBI's task was merely to target the government-prescribed goal on inflation or growth or both.

The Financial Sector Legislative Reforms Commission (FSLRC), as the Srikrishna panel was called, had this to say: “The objectives of the Reserve Bank in the discharge of its monetary policy function must be provided by the Central Government, in consultation with the Reserve Bank Chairperson, by way of a written statement…”.

The Urjit Patel report, on the other hand, talks of the Reserve Bank setting its own goals – more or less. This is likely to a point of tension between the finance ministry and the RBI. In the FSLRC version of the Monetary Policy Committee, membership would have been loaded in favour of government nominees. The Srikrishna MPC would have seven members, two from the RBI, including the Governor, two appointed by the central government in consultation with the RBI, and three more appointed only by the government. This would have tilted power away from the RBI to the finance ministry in the MPC.

In the Urjit Patel recommendations, the MPC will be a five-member committee nominated entirely by the RBI through an internal process. The report says: “The Governor of the RBI will be the Chairman of the MPC, the Deputy Governor in charge of monetary policy will be the Vice Chairman, and the Executive Director in charge of monetary policy will be a member. Two other members will be external, to be decided by the Chairman and Vice Chairman on the basis of demonstrated expertise and experience in monetary economics, macroeconomics, central banking, financial markets, public finance and related areas.”

The finance ministry is unlikely to take kindly to its exclusion from nominations to the MPC. The Patel MPC would be similar to what the RBI now has, a Technical Advisory Committee appointed by itself.

A minor point of difference between the Srikrishna report and the Patel one is that, in the former, the Governor can overrule the MPC and give his reasons for the same. In the Patel report, it is the MPC and not the Governor who gets primacy. This has the advantage of pitting the MPC against the finance ministry and not just the Governor. It also empowers the RBI as an institution as opposed to merely making it something about the Governor.

The key bone of contention will clearly be the Patel committee's suggestion to target only retail inflation. It will surely lead to heart-burn in North Block. Reason: retail inflation is currently close to double digits (9.8 percent) and is strongly influenced by food prices. Two significant determinants of food inflation are government-set minimum support prices (MSPs) of foodgrain (especially rice, wheat, pulses and oilseeds), and government cash doles which tend to push up demand for protein-based food items (milk, eggs, fruit, veggies and meat) – the main reason for recent high and persistent inflation. If the RBI targets only CPI inflation, the government will be forced to act on subsidies quickly to prevent the central bank from stamping even harder on growth to bring down the CPI.

The RBI has so far been targeting a mix of wholesale (WPI) and retail inflation indices, and, since wholesale inflation is lower than retail, the government probably got away with a lower interest rate than what the CPI inflation would mandate. Now there is no WPI figleaf left to cut rates.

The next one year will be one of intense shadow-boxing between the RBI and the government - both the current one and its successor after May - as MSPs are bound to be raised before an election, and hikes in diesel and petro-products are still needed to bring down subsidies. If deficit targets are not met or met with dubious accounting practices, the RBI will be forced to step delay rate cuts.

The final point of tension between North Block and Mint Street will be the impact of RBI policies on the government’s cost of borrowing. If rates stay high, yields on government bonds will remain high.

One thing is certain: if the Patel approach is representative of thinking in the Raghuram Rajan-led RBI, we should rule out any rate cut when the RBI meets on 28 January. Chidambaram will have to keep walking alone - and into the sunset after May.

The writer is editor-in-chief, digital and publishing, Network18 Group