Should the MPC focus on core or headline inflation? RBI must debate

According to Kapur, 3.5-4 per cent level for CPI is a healthy target to maintain for the MPC.
As the Reserve Bank of India (RBI) engages in an internal review of the monetary policy framework, economists are of the view that there is scope for certain fine-tuning, especially in fixing the level of inflation that would be consistent with the potential output of the country. 

Besides, whether monetary policy committee (MPC) should focus on core inflation or the headline inflation consisting of fairly unstable food and fuel prices should also be debated, economists say.

However, the issue here is finding out the potential output of the economy itself is a difficult task to begin with. But the general consensus is it should be the level where the capacity utilisation hits near about 85 per cent, or crosses it, from the present low-70 per cent level.  There can also be a debate whether the framework should follow single policy objective or multiple. In every aspect though, economists are divided on the right approach. 

State Bank of India (SBI) group Chief Economic Advisor Soumya Kanti Ghosh said the MPC cannot afford to only have inflation as the objective. There should be multiple objectives, with growth mandate firmly embedded in it. 

“The mandate for the MPC is a little restricted. There is a clear distinction between the MPC and the RBI now. Targeting inflation cannot be the sole mandate in a country like India. It is something for the developed country where growth is not a concern anymore,” said Ghosh. 

But Gaurav Kapur, chief economist of IndusInd Bank, differs on that. “India had multiple indicator approach before the MPC, but it did not produce desired results. A monetary policy has to be clear and clearly stated and communicated. Monetary policy globally is getting limited in its ability to push growth, as the central banks tinker with other macroprudential tools,” Kapur said.  

Generally, economists side with the latter’s thinking. “Multiple objectives are not a good thing. They confuse the markets,” said a senior economist not wanting to be quoted. 

In August, the three-year tenure of external members in the MPC also comes to an end. Economists say they see no reason for a change among the members as they showed independence and offered divergent views, in the true spirit of a committee approach. However, three members being from the RBI itself means it is always the view of the central bank that gets translated into action. 

It is, however, the consensus that the policy framework has served the country well, as in the three and half years of it being in the operation, inflation has remained largely under control except for the latest prints. According to the mandate given by the government, the RBI has to maintain inflation at between 2 and 6 per cent, with the mid-point at 4 per cent.  
Economists have also varied opinion about whether a 4 per cent inflation is good enough. 

According to Kapur of IndusInd, there is a scope to lower the inflation target. “Inflation is not a good thing. Inflation globally is going down, food and fuel shocks are essentially short-term. The oil dynamics globally have changed in our favour as supply has outstripped demand, and the fossil fuel concerns will keep oil prices under check,” Kapur said, adding the weightage given to food in inflation needs some revision, but that is not a task of the RBI. 

According to Kapur, 3.5-4 per cent level for CPI is a healthy target to maintain for the MPC. 

However, some other economists say the MPC should be allowed to keep inflation at a slightly higher level than what the present target of 4 per cent is. 

“A slightly higher level of inflation for a developing economy is actually good. It improves the nominal growth and improves tax collections for the government. Inflation at 4 per cent may not be that appropriate to go with India’s potential growth rate. The bigger question here is whether the MPC should target headline inflation at all, or just focus on the core,” said the economist quoted above. 

They say it won’t be an easy task for the RBI to review an established framework. The central bank will have to calculate the neutral rate, the global environment, unemployment rate, wage growth and outsized geo-political risks that pop up frequently. 

They have to consider currency movement, and an ideal exchange rate. Economists say the growth and inflation tradeoff is no longer operative because of the central bank interventions. 

Instead, the RBI must consider that apart from the headline inflation, inflationary expectations and inflation as cost of funds are also assuming an equal importance.

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