Will Fed model help RBI become more effective?

Further, the committee, headed by the central bank governor, will have two outside experts, and its accountability will be ensured by requiring it to issue a public statement if the inflation target is missed for three consecutive quarters.

Currently, the RBI works with a flexible, somewhat-unclear mandate of ensuring price stability and optimal economic output.

The dual mandate can give rise to cross purposes. For instance, in recent times, the Indian central bank has often been perceived to be at odds with the government and the finance ministry as growth slowed down in recent years while inflation continued to run amok.

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The previous governor, Duvvuri Subbarao, hiked interest rates 13 times in about two years to tame prices, even as the finance minister was seen to be nudging the central bank chief to cut interest rates in the face of sluggish growth.

With a dedicated panel appointed to decide on monetary policy, along the lines of the 12-member Federal Open Market Committee (FOMC) in the U.S., and with clear inflation targets in mind, it should help the central bank convey its monetary policy stance to the government and set the market’s expectations in a clearer manner.

By following an inflation target, the RBI would also have in place a more objective, rather than subjective, method of deciding monetary policy stance. This would help the central bank attain greater independence in the way of its working.

Of course, setting clear-cut targets for inflation is not without risks. For one, it threatens to make the monetary policy-setting process more mechanistic even as “some part of inflation such as food and fuel is not easily controlled by monetary policy”, as the report admits.

For instance, experts have said part of the reason behind the high inflation of recent years is bottlenecks in the economy’s food supply chain. Monetary policy is clearly more effective at taming demand-led inflation (more money chasing the same amount of goods) rather than one emanating from the supply side (limited stock coming to the market).

In the inflation saga of the recent years, critics of the central bank often labeled it of administering textbook solutions in a time they wouldn’t work, due to the unconventional nature of the problem.

An inflation-targeting process to monetary policy could accentuate the textbook approach even more, even though the upside is: it would send a clear message to the government that it has no option but to set its own house in order.

Finally, as the report adds, inflation-targeting “is inherently a medium-term framework because of the long and variable lags in monetary policy transmission. The lack of immediate demonstrability of outcomes can result in ambiguous perceptions of the policy stance.”

But it appears that the RBI may be leaning towards the clearer goal of controlling inflation via monetary policy as its raison d’etre and leave the job of boosting economic growth to the government’s fiscal policy.