The first quarter review of monetary policy 2011-12 announced by the Reserve Bank of India (RBI) on July 26, 2011, raised repo rate under liquidity adjustment facility (LAF) from 7.5 per cent to 8.0 per cent. This is the eleventh successive increasing in the main policy rate since March 2010, signifying continuing monetary tightening in fight against inflation.
The cumulative increase in the repo rate during this period is 325 basis points, which is the sharpest tightening since introduction of LAF in June 2000, within a span of a little over one year. The latest rate hike was effected despite some apprehensions in the industry and banking that further monetary tightening will stifle economic activity.
The previous phase of tight policy witnessed 10 successive increases in the repo rate during January 2006 through October 2008 during the regime of the previous Governor, Dr Y.V. Reddy. The cumulative increase in the repo rate during this period was 300 bps. The current phase of monetary tightening began in the backdrop of year-on-year WPI inflation of close to 9.0 per cent during the year 2010-11 as against the projection of 5.5 per cent.
As compared with the indicative projection of about 4.0-4.5 per cent inflation in the current financial year (as per the Monetary Policy Statement 2011-12), inflation in last three months remained stubbornly above 9.0 per cent.
POLICY FEATURES
The present monetary policy strategy of the RBI has some characteristics which appear to be similar to the ‘inflation targeting' framework adopted by several leading central banks, beginning with the Reserve Bank of New Zealand in 1990. Firstly, both the recent experience and that during 2006-08 revealed institutional commitment on part of RBI to pursue price stability as the primary long-run goal of monetary policy. This is the fundamental feature of implicit ‘inflation targeting'.
Secondly, since the adoption of ‘multiple indicators approach' in 1998-99, RBI moved away from exclusive reliance on monetary aggregates for decision-making to an information-inclusive approach using various macroeconomic indicators.
Thirdly, there have been significant improvements in the RBI communication strategy in terms clarity and transparency, although a lot more to be achieved in this regard, including releasing the minutes of the meeting of Technical Advisory Council on Monetary Policy and technical details of RBI projections of growth and inflation.
The above constitute as three important components of the salient features of ‘inflation targeting' as enlisted by noted economist and former central banker Frederic Mishkin.
Of course, the key features such as announcement of explicit targets for inflation, accountability of the Governor on failure to achieve the targets are not part of the present monetary policy framework in India. For the critics of such an approach, it is important to note that the primary focus on price stability is not asymmetric.
DEFLATION CONCERNS
A central bank pursuing price stability is equally concerned about deflation and ‘zero' inflation, as it is about high inflation. In a situation of economic slowdown with depressing tendencies for inflation, there is a risk of inflation falling below the lower band of inflation target.
So, an ‘inflation targeting' central bank will equally strive to pull inflation above the lower band so that price stability is maintained, which is implicitly consistent with output stabilisation objective.
Cross-country evidence suggests that monetary policy has very limited potential to prop up economic activity on a sustained basis. So there is an increasing consensus to allow monetary policy to do what it can do — pursue price stability.