Redesigning the Indian monetary policy framework

The classical central banker’s dilemma is how to address the growth versus inflation conflict. The prevailing orthodoxy has remained an independent monetary policy using base interest rates as the primary management tool.

Often this fine line involves balancing the demand from the private sector for lower policy rates, as the best tool to assist economic growth, against what the "correct" rate should be to maintain inflation levels to a specified target.

What we have observed in India during the last 10 years is by no means unique: businesses have called continually for a substantial reduction in the policy rate while the Reserve Bank of India (RBI), mindful of the damaging effects of past high inflation experiences, has maintained a gradualist interest rate easing stance.

The RBI has formally adopted inflation targeting, aiming to keep the inflation rate at 4 percent (with a tolerance band of 2 percent). On the surface this suggests that India’s monetary policy is a developed one as it is identical to Western central bank practice, whilst simultaneously assisting increased transparency: market participants should be able to gain better insight about the drivers of the RBI’s policy actions.

In other words, the RBI has exercised an orthodox monetary policy stance in recent years, with the central doctrine being that controlling price inflation is the top priority.

For such a policy to work in anything like an efficacious manner it is imperative that the macroeconomic variable being targeted is a reliable one and must reflect underlying inflationary conditions accurately, not transitory factors. Relying on an inappropriate barometer of price pressures runs the risk of flawed decision making.

But as Chart 1 shows, the current target metric is closely correlated to food price inflation, which suggests a review of the CPI basket and its current constituents may be called for. The CPI basket appropriate to a developing economy would be expected to be changing regularly as the economy moves along development phases.

Chart 1: The key RBI target variable (CPI) RBI is closely linked to food price inflation
Source: Reserve Bank of India

We have noted the adoption of inflation targeting and an independent policy setting committee, which have been long-standing features of Western central banking frameworks, but what of the effectiveness of policy transmission itself?

With the financial system dominated by banks, the key transmission channel has been the private market lending rate. But the impact of rate cuts has lagged behind the RBI’s expectation. In general the RBI is desirous of banks passing on lower interest rates to borrowers, but this process has been slow, with banks citing that funding costs remain high.

Concerns about losing customers to small saving schemes (which offer relatively higher interest rates) have prevented banks from lowering deposit rates (see Chart 2). In this context, the government's recent decision to lower interest rates on small saving schemes is a sensible move.

The introduction of marginal cost of funds-based lending rate (MCLR), the lending rate calculation methodology based on marginal cost of funds, by the RBI is an equally commendable step. But the process of reforming the transmission mechanism does not end there.

For instance, even under the MCLR regime, there has not been a visible improvement in transmission, as banks still find ways to make the MCLR more or less equivalent to rates calculated under the old methodology.

Chart 2: The deposit rate has been less responsive to policy changes
Source: Reserve Bank of India. Note: Deposit rate is calculated based on figures given by India’s largest Bank SBI. For 2016, data is up to July.

Ideally the market should seek to establish an external interest rate reference benchmark, which would form the basis for pricing financial products and thereby make the cost of financial institutions’ liabilities move in line with changes in policy rates.

A genuine market indicator reference rate would improve market transparency whilst also facilitating more efficient monetary policy transmission. This is an area that central banks can and do get involved in facilitating.

India is in the midst of a gradual transition towards a market-oriented economy. Recent developments cementing the autonomy of the RBI and the emphasis on an orthodox monetary policy framework are indicators that from the central bank perspective things are moving in the right direction; it is the next steps that remain critical.