12 July 2016 15:11:48 IST

Inflation or growth: what should the RBI focus on?

Government has handed over monetary policy making to Monetary Policy Committee

Much has been said about RBI governor Raghuram Rajan’s single-minded focus on inflation while framing monetary policy decisions. The debate on whether the RBI should steer its policy decisions based on growth or inflation — both requiring opposite solutions — has been rife for years.

Now, with the amendment of the RBI Act, the Government has set the ball rolling by handing over the monetary policy making in India to a Monetary Policy Committee (MPC).


While the panel will consist of six members — three from the RBI and three from the Government — it is unlikely that the monetary policy framework will undergo major structural changes, even if some allied bureaucrats of the Centre wish to detract the MPC’s main objective from inflation to growth.

This is because the inflation targeting framework in India is in line with global practices. What can be reviewed, though, is the targeted inflation range or the time frame by which it needs to be achieved, as a desperate attempt to revive growth in the near term.

How it started

It is a known fact that the central bank in any country manages money supply and interest rates through various monetary policy tools. In a nutshell, monetary policy is a part of the general economic policy of the Government and thus, helps achieve some of the economic policy goals.

This means that RBI’s monetary policy should seek to achieve certain economic objectives, such as promoting growth, controlling inflation and maintaining a stable exchange rate.

The opposition

While this sounds good in theory, in reality, juggling various objectives is hardly an easy task. For simplicity, let us take RBI’s two main objectives — growth and inflation. To kickstart growth, there is a need to stimulate demand by inducing spending, which can be done by increasing the supply of money in the economy.

The RBI can either directly affect the money supply, as was traditionally done, or indirectly impact the cost and availability of credit by changing interest rates, as is done now. The RBI thus primarily tweaks interest rates to stimulate borrowings and thus, investment.

Controlling inflation, ironically, requires just the opposite steps — reduce the money supply, and thus reduce spending, which means increasing interest rates.

To resolve this, the RBI set up an Expert Committee under Deputy Governor Urijit Patel to revise the monetary policy framework. The report, which was published in January 2014, proposed a new framework for monetary policy — flexible inflation targeting.

Subsequently, the RBI, in concurrence with Finance Ministry, put in place the framework that focuses on inflation targeting.


Inflation targeting, as a policy tool, is more than two decades old and there is very little debate on its advantages. It clearly provides the central bank an explicit mandate to pursue price stability as the primary monetary policy objective.

By clearly stating the inflation targets, there is more predictability in its decision-making. It has been quite evident that since adopting this framework, there has been a greater degree of consistency in monetary policy making, which is comforting.

In sync with global practices

The inflation targeting framework in India is also in line with the global practices. There is a convergence of views in both developed and developing economies that price stability has to be the main objective of monetary policy.

According to a handbook published by the Bank of England, State of the Art of Inflation Trageting-2012 , 27 central banks have adopted inflation targeting as their monetary policy framework.

In a majority of the countries, — 15 out of 27 — the inflation target is decided both by the government and the central bank. In nine countries, the central bank sets the target, and in three cases — Norway, South Africa and the United Kingdom — the target is set by the government.

Among the nine industrialised countries, Sweden is the only country in which the government is not involved.

All these 27 countries use the consumer prices index (CPI) as their operational target — using the headline figures, rather than the core measure.

The consensus is that inflation above 3-4 per cent level is a cause for concern. All this indicates that the monetary policy framework set in India is in sync with most other countries’. The Consumer Price Index (CPI)-based inflation target of 4 per cent (+-2 per cent) band over the medium term has been set in India, in line with the Urjit Patel committee recommendations.

MPC decision making

The new MPC will meet four times a year to decide on monetary policy by a majority vote. And if there’s a tie, the RBI governor will get the deciding vote.

In most inflation targeting countries, decisions are steered by a committee. As far as the decision-making process is concerned, 18 countries that target inflation decide on policy rates based on a majority vote, rather than a consensus. The governor usually has the casting vote.

While there is no clear pattern on the composition of the MPC, very few countries have government representation on the decision-making committee. These include Colombia, Guatemala and the Philippines.

In other countries, such as Hungary, Romania, Turkey and the UK, the government is a mere observer and does not have the right to vote. It is here that our newly constituted MPC may be out of sync with practices in most other countries.

With India Inc. and the Centre long clamouring for rate cuts to spur growth, it needs to be seen if the MPC will be tempted to favour growth, while allowing itself some leeway on meeting the inflation target in the near-term.