The Reserve Bank of India Headquarters in New Delhi (Photographer: Kuni Takahashi/Bloomberg)

India Eases Into Monetary Policy Committee Led Central Banking


The process of overhauling monetary policy making in India is now near complete.

A monetary policy committee (MPC) will soon decide on the course of interest rates in India following the appointment of committee members today. If finance ministry indications are anything to go by, the MPC will conduct the October monetary policy review. It will do so on the basis of a flexible inflation target of 4 percent (+/- 2 percent) that has been agreed upon between the government and the Reserve Bank of India (RBI). The nominal anchor for monetary policy is now the consumer price inflation index which shapes inflation expectations.

To understand just how significant these changes are, just think back three years.

When Raghuram Rajan took over as governor in September 2013, the RBI followed a multi-indicator approach to monetary policy. To determine the trajectory of inflation, the RBI looked at both the wholesale and the retail inflation indices. Divergence in these indices was not uncommon which often left the RBI in a spot. Since the central bank followed a multi-indicator approach it had no clear target for inflation. The RBI always had a medium term objective of bringing inflation down to near 4 percent but actual inflation fluctuated wildly away from that objective. Monetary policy was also essentially the preserve of the RBI governor. There was always advise from internal and external experts but it eventually came down to what the RBI governor decided.

That was the past. In the present, an MPC will decide collectively on monetary policy based on a target and a fixed nominal anchor. It will also have to send a report to the central government should it fail to meet its stated objective for a period of time.

Given how significant the change is, the government and the RBI seem to be easing the economy and the markets into the new framework. The appointments to the MPC announced on Thursday will leave little room for immediate finger-pointing on any perceived government influence on monetary policy. It will also be tough for anyone to argue that the MPC collectively does not have enough experience or understanding of the Indian economy to set appropriate monetary policies. Finally, it may put a stop to speculation that one of the reasons Raghuram Rajan exited after a three-year term was because of differences with the government on inflation control.

An Academic Tilt To The MPC: Good Or Bad?

The three members appointed by the government to the MPC are all academics.

Chetan Ghate, associate professor at the Indian Statistical Institute is among them. Ghate has worked with both Rajan and Patel. He was part of the Urjit Patel committee that recommended this new monetary policy framework and has also been a member of the RBI’s hand-picked technical advisory committee. It’s likely that he will be in sync with the central bank’s thinking on key macroeconomic issues.

Pami Dua of Delhi School of Economics and Ravindra Dholakia of the Indian Institute of Management, Ahmedabad are the other two who have been nominated. Both are respected academics who have covered a wide range of topics during the course of their research careers.

It could be argued that this would tilt the committee towards academicians, especially since Governor Patel’s experience in ground-up policymaking is also limited. However, the committee will also have R Gandhi, a RBI lifer, and Michael Patra, who has been deeply involved with monetary policy making at the central bank for many years.

Also, the government’s options were limited. Consider a scenario where the government had picked either former bureaucrats or economists linked to government funded research organisations. Allegations would have flown thick and fast that the government is trying to influence monetary policy with its selection. Appointing academics has avoided that.

India Eases Into Monetary Policy Committee Led Central Banking

Does The Course Of Monetary Policy Change?

With the process of setting up the MPC over, the next question is whether the course of monetary policy would change now that six minds are making decisions collectively. In the near term, it seems unlikely.

The RBI has committed to bringing down inflation to 5 percent by March 2017. Any immediate policy decisions will be based on whether that target appears achievable. Only if the committee is of the view that there is scope to undershoot that 5 percent target will the committee be able to cut interest rates. With consumer price inflation falling to near that target in August, a rate cut is a possibility but not a certainty. At present, when growth is relatively steady and financial stability is not a concern, inflation will dominate the MPC’s mindspace.

We will know more about the areas of focus for MPC members when the minutes of these meetings are released with a lag. As is the norm across many global central banks, while voting patterns will be disclosed with the policy decision, the minutes will follow a few weeks later.

The mettle of the MPC will be tested in tougher times. Consider a scenario when consumption driven growth picks up and pushes up inflation, which, in turn, impacts investor confidence. That’s the time when we will know whether the collective wisdom of six experts driven by clear targets will work better for the economy than the judgement of one RBI governor.