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Centre will set inflation target, not Rajan’s RBI

The new monetary policy framework will clip RBI’s wings and stature, which soared under Governor Rajan.

Shailendra Tyagi  18th Oct 2014

nder the proposed new monetary policy framework, the Central government will set the target for maximum permissible inflation, and not the RBI, say sources in the government. Under the current regime, the RBI Governor has been setting the CPI (Consumer Price Index) inflation target, a task that the Centre will take over. The new framework will clip RBI's wings and its stature, which soared under Governor Raghuram Rajan, who sought a degree of autonomy from the Central government, something his predecessors did not do. It was Rajan who adopted the much more stringent CPI, rather than continue with WPI (Wholesale Price Index), which shows lower inflation in most instances. Incidentally, the Chicago School economist was hand-picked by former Prime Minister Manmohan Singh, himself an inflation "hawk" when he was the Finance Minister in 1992-96.

This is being done, sources say because Rajan is someone who "is simply not supporting India's growth story".

Deepak Kapoor, the director of ADC Legal, says, "He (Rajan) should have been more pragmatic. All interest-rate sensitive industries are bleeding due to his stubbornness in keeping interest rates high." The new framework would be more growth friendly, he adds.

Among other things, the new framework will require the government to set up a medium term (retail) inflation target, as well as a multi-member new monetary policy committee (MPC), which would try to achieve that target. Right now, the RBI Governor takes monetary policy decisions along with his subordinates. Setting up of interest rates is the most prominent of these decisions.

The RBI appointed Urjit Patel Committee has however recommended that the inflation target should be set by the Central bank.

Deepak Kapoor acknowledges that the management of the monetary policy is a challenging task but still supports the government taking control of setting inflation targets because "monetary policy ultimately is one of the tools of fiscal management". After all, it is the government which is directly accountable to the people when it comes to increasing economic growth and bringing down inflation. Kapoor explains that wherever Central banks have been in sync with the government of the day (like in US), they have been able to deliver better results. The Federal Reserve had gone into uncharted territory by following this unconventional monetary policy to bring the US economy out of a recessionary trend successfully. Likewise, "Rajan should have taken some (unorthodox) risks" recommends Kapoor, especially when inflation in India has shown a decline in recent times.

Rajan's backers, however, say that it will be dangerous to leave the baton in the government's hands "due to its politics-oriented political and economic vision". RBI sources argue that "the government's sole ambition is to win the next election, so while its economic policies may be hugely popular (providing subsidies), these may wreak havoc with the fiscal deficit". They argue that the political economy of subsidies is well understood in India "and the nation has already paid a heavy price of such profligacy in 1991". High fiscal deficit means higher government borrowings, leading to higher interest rates. And if the government chooses to print the money to finance its deficit, a high probability if the new monetary framework gets approved, then it would ultimately lead to higher inflation, they say.

The Constitution provides for a system of checks and balances and the RBI's conduct of monetary policy is one such check and balance on government's profligacy; therefore the conduct of monetary policy should best be left with the RBI not only due to its institutional expertise due to the fact that RBI's integrity has never been in doubt, those close to Rajan aver.

However, it seems that the Union government is in no mood to hand over the control of inflation policy exclusively to an unelected group of Central bankers, especially when led by a monetarist who has got kudos from Euromoney for his tight money policy, despite its effect on growth.

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