Recently, a working group of the Reserve Bank of India (RBI) submitted its report on the operating procedure of monetary policy in India. The report deals extensively with the practical aspects of monetary policy implementation — covering techniques and instruments to be used, methodologies to be adopted, the sequencing of the central bank's money market operations, and so on.

In short, elaborate ground rules on how monetary policy should be implemented through and in the money markets.

What about objectives?

But what is inexplicable about the report is its reticence about the objectives (of monetary policy) which are sought to be achieved by the laid out operating procedure. Surely, when you lay down policy implementation ground rules, the objective sought to be achieved by such policy implementation also should clearly be up in the forefront.

So, what is the RBI's monetary policy seeking to achieve?

The report says “…there should be a single policy rate to unambiguously signal the stance of monetary policy to achieve macroeconomic objectives of growth with price stability”.

One cannot but note here that the precision and detail which the report offers on the operating procedure is conspicuously absent when it comes to talking about policy objective(s).

Any economic policymaker seeks to achieve the general macroeconomic objective of growth with price stability. There is nothing earthshaking about that.

But one wonders if the RBI can have such amorphous objectives such as “growth with price stability”? Would it not have been necessary to drill down the objective to some specific number, say, some level of annual price increase?

In the instant case, is not laying out the operating procedure without a specific policy objective akin to building a superstructure without the foundation?

Inflation targeting

It is inexplicable why so much energy should be expended on policy operating details when we do not know what is sought to be achieved by the broader policy. Proceeding further, it all ultimately boils down to what economic objective the RBI should have. Detailed operating procedures can then be laid out for implementing policy to attain that objective.

In this regard, the RBI has gone on record that it cannot be a pure inflation targetter. About a year ago, the RBI adduced some five reasons why inflation targeting is neither desirable nor practicable in India. (This line was reiterated recently also.)

Among the reasons was that inflation in India, more often than not, was supply driven and that too particularly supply shocks in food items. The other key reason was that it was almost impossible to have a single representative rate of inflation for a vast country with large population, diverse geography and fragmented markets.

To be sure, leaving out food prices from inflation measures because of their inherent volatility does have its merits.

The question is whether this argument — that “supply shock” driven inflation is beyond the pale of monetary policy — should be confined to food items (and energy) only.

For instance, can we say that supply shocks in a range of industrial raw materials are beyond the pale of monetary policy? The risk is that of the “supply shocks” argument causing policy inertia. Ultimately, is not overall nominal demand (and the overall price level), whatever the supply shocks, always underpinned by the monetary policy stance?

Further, one notes that economic commentaries in India have predominantly focused only on goods (food or non-food) prices and inflation in such prices. The RBI also seems to be focused only on the prices of non-food manufactured products.

Why is inflation in services — which account for some two-thirds of GDP — left out in the inflation measures? Prices of most of the services of everyday consumption — be it housing, healthcare, education, transportation among others — have increased manifold in the past 10 years. (A comparison of the nominal and real GDP time series would strip out the overall annual inflation in services in the past decade. It is easily in the double digits).

The vastness of the country and its diversified, fragmented profile do pose problems.

But here, one wonders if the RBI makes effective use of its equally well spread out branch/office network to reach out into the Indian hinterland. How closely does the RBI study regional/local economies? Will not an intensive focus on each regional economy provide a better picture of nation-wide real economy, financial and price level conditions?

In this regard, would something on the lines of the district Federal Reserve Banks in the US be useful in India? Is there a case for significant organisational restructuring here? An impetus to major organisational restructuring in the RBI could even catalyse the Government's move towards integrated national markets.

The other key reason the RBI gave for not targeting inflation is that it is not possible in an “impossible trinity” situation. But this begs the question: Why should RBI try to manage the “impossible trinity” at all? For, it is indeed a truism that with a largely open capital account and a managed exchange rate, domestic monetary policy is compromised. If you want to target inflation, better let go of the exchange rate. That seems to be a question of priorities.

Freeing the exchange rate

Letting go of “close” exchange rate management need not necessarily result in economy disrupting currency market volatility. Enhanced currency market volatility there sure will be — but that could well contribute to the development of a self-balancing mechanism in all markets — be it in the real economy or in the markets for financial assets such as stocks and bonds — as investors would then have to factor in the dynamic interaction of two-way currency risk, interest rates policy, bond yields and corporate sector profitability prospects into their decisions. In short, no one-way street investing.

On the contrary, the intensive exchange rate management the RBI does — evidenced by the accumulation of some $260 billion in forex reserves in the last 8-9 years — almost acts as a “put option” ( a la Greenspan and Bernanke puts) guaranteeing high returns for foreign investors in our asset markets.

It is no accidental correlation that some of the strongest returns from Indian stock markets (and asset markets in general) have accompanied some of the largest increases in the country's forex reserves. Again, it is no accidental correlation that some of the strongest profits growth in the Indian corporate sector went hand in hand with sharp increases in the forex reserves.

Tight management of the exchange rate presumes immaturity on the part of various economic agents — be it the foreign investor, the exporter, the importer or domestic industry. Such tight management almost eliminates two-way currency risk, hands out profits on a platter to investors and is a key causative factor behind the high cost domestic economy we are grappling with now. Ultimately though, if the stubbornly high inflation were to undermine foreign investor sentiments, it would have ironically encouraged the very behaviour — fair weather investing — it hopes to avoid or counter.

(The author is Vice-President (Economic Research), Shriram Group Companies, Chennai. The views are personal.)

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