India: Survival of the FITtest

Why was there so much scepticism about inflation targeting in India before its advent and even during its first innings, especially among former Governors and Deputy Governors of the RBI, my students asked. I paused, knowing I was about to tread on thin ice. Perhaps, I replied warily, it conjured up images of a nerdy, thickly spectacled, hair all askew central banker single-mindedly going after inflation till the economy went limp and gave up the ghost.

Perhaps, it went against the grain of the image carefully crafted of the RBI at that time, that of a full-service central bank. But that, I explained, was the least tractable: Inflation targeting is about the conduct of the monetary policy function and is perfectly compatible with all the other functions of the RBI. Perhaps, and this seemed the most cogent, it limited discretion in setting monetary policy goals and assigning weights to them. Inflation targeting gives primacy to price stability, but once that is achieved, the central bank is free to pursue other objectives that its dual/multiple mandate entails.

I did, however, firmly emphasise to my students that the impression of the inflation targeting practitioner as a nerdy inflation nutter has to be dispelled. Nothing can be farther from the facts. Inflation targeting is all about stabilising the economy’s growth around its potential path. How does one know that the economy is growing beyond what its potential allows? This overheating will show up in inflation! Analogously, when the economy is growing below its potential, the most observable symptom will be deflation.

By symmetrically addressing the symptoms, inflation targeting prepares the ground for achieving an economy’s potential and thereby creates the environment for strong, sustained growth to accrue.

Preparing the Pre-Conditions/Guideposts
The establishment of inflation targeting in India was spearheaded by Governor Dr Raghuram Rajan, who was by then a person of international eminence and, importantly, had fought shoulder to shoulder with the RBI as the Chief Economic Adviser, Ministry of Finance, Government of India, to defend India against the taper tantrum and restore stability. 

Driven by a formidable capacity for hard work, the gift of eloquence and the courage of his convictions, he expressed the view at the very outset of his tenure that “The primary role of the central bank, as the RBI Act suggests, is …to sustain confidence in the value of the country’s money. Ultimately, this means low and stable expectations of inflation.”

In September 2013, an expert committee was appointed under the chairmanship of Dr Urjit Patel, then Deputy Governor and destined to implement inflation targeting in India as Governor, to revise the monetary policy framework within a five-pillar approach comprising: clarifying and strengthening the monetary policy framework, strengthening the banking structure, broadening and deepening financial markets, fostering financial inclusion, and improving the system’s ability to deal with financial stress. 

I was Member-Secretary of the committee. Together with a select, hand-picked band of colleagues from the RBI who formed the secretariat, we burned the midnight oil to give life to a blueprint for the future. The committee submitted its report in January 2014. Its recommendations on the choice of a nominal anchor for monetary policy, decision-making processes, instruments and operating procedure, transmission and open economy monetary policy provided the intellectual edifice for fashioning the new regime.

Inflation was chosen as the nominal anchor for monetary policy in India. Well ahead of formal adoption, the RBI began sensitising the public about the choice of metric for the nominal anchor, as this would involve a shift from the WPI to the CPI. From the October 2013 monetary policy review, retail inflation measured by the new CPI was analysed, and projections in the form of fan charts were provided for the first time, effectively marking the beginning of the transition. 

Two challenges presented themselves: first, in the absence of any prior experience with CPI inflation, how should the RBI react to it? Second, 46% of the new index comprised food and beverages – as against 24% of the WPI based on 2004-05 – rendering the inflation process volatile and prone to supply shocks over the first-round incidence of which monetary policy had no control. Therefore, the commitment to the nominal anchor would need to be demonstrated by timely and even pre-emptive policy responses to risks from second-round effects in order to anchor inflation expectations.

The reality of doing so involved careful craftsmanship. Inflation measured by the CPI had reached a peak of 11.5% in November 2013. Bringing it down to a more tolerable level was a formidable task because the costs of disinflation in terms of the sacrifice of output could be substantial. In a cross-country setting, each percentage point decline in trend inflation costs about 1.4 percentage points of a year’s output.

Accordingly, the RBI chose a gradual approach over a ‘cold turkey’ approach or a sharp tightening of monetary policy.  It opted for a medium-term horizon of disinflation spread over a multi-year time frame. A glide path was set up that would bring down inflation to 8% by January 2015 and 6% by January 2016.

Fortuitously, a collapse of commodity prices enabled CPI inflation to ease to 5.2% in January 2015 and 5.7% in January 2016. The renewal of the commitment to fiscal prudence under the amendment of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, in 2012, and the regaining of external sector strength and resilience, marked by the steady reduction in the current account deficit and the resumption of capital inflows, greatly helped the disinflation. During this period, the RBI also developed alternative technologies for forecasting inflation in a consistent and reliable manner. After all, the core of inflation targeting is inflation forecast targeting.

Implementation
India was a late entrant into inflation targeting. At the time of writing the report of the expert committee, more than 30 countries had already adopted it in some form or other, but being a late mover has advantages. We looked at each country's experience and cherry-picked the best parts of each while keeping in mind what suits India-specific conditions. We called it FIT or flexible inflation targeting, with the hope that it would survive the test of time.

In view of the stiff opposition to inflation targeting all around us, the RBI signed an agreement with the government in 2015 to put the new framework in place even prior to the legislation that amended the RBI Act to bring the new regime into force.

The key features were a glidepath to bring inflation gradually down from 10% to 6% by January 2016 and 4% for all subsequent years up to 2020-21; a band of +/- 2% around the target to account for measurement errors and supply shocks; the RBI to establish an operating target and an operating procedure for monetary policy through which the operating target is to be achieved; and failure was defined by the condition that inflation remains above 6% or below 2% for three consecutive quarters. We borrowed the accountability procedure from the Bank of England – the letter – but adapted it to Indian conditions – it is not an open letter. 

In it, the RBI is required to provide the reasons for the failure, propose remedial measures and indicate the expected time to return inflation to the target. The RBI would publish a document explaining the sources of inflation as well as forecasts of inflation for the next six to eighteen months. This became today’s bi-annual monetary policy report.

In 2016, the RBI Act was amended to enact inflation targeting in India, incorporating the provisions of the framework agreement. The amended Act by itself is a landmark in the history of not just monetary policy in India but of the RBI.

For the first time, the preamble explicitly gave the RBI the power to conduct monetary policy in a modern framework, befitting the times we live in. For the first time, a goal was assigned to the conduct of monetary policy – price stability, keeping in mind the objective of growth.

Also for the first time, the monetary policy decision was entrusted not to the Governor but to a committee – the monetary policy committee or MPC. The MPC would be chaired by the Governor, with two internal or ex-officio members and three external members for whom qualification criteria were indicated. For the first time, the monetary policy decision would emerge out of a voting process with each member of the MPC having one vote, and the Governor would have a casting vote if there is a tie. To date, the casting vote has not been used.

On June 27, 2016, the Gazette of India notified the conditions of accountability, which were the same as in the 2015 agreement, the method by which members of the monetary policy committee would be appointed and the terms and conditions of their appointment. On August 5, 2016, the inflation target and the tolerance band around it were notified. On September 30, 2016, the MPC was announced. October 1 was a Saturday (a holiday for RBI), and October 2 was a Sunday. The monetary policy committee met for the first time on October 3 and made its decision on October 4. The rest is history.  

This is Part 7 of the Masterclass with Michael Patra.

In Part 8, Patra distils four lessons from India’s flexible inflation-targeting framework after the trials and tribulations of war and the pandemic.

Masterclass with Michael Patra: Previous Sessions

Part 1
Origins, Ideas and Institutions
Michael Patra begins the masterclass by tracing how central banks evolved from fragile monetary experiments into institutions entrusted with preserving trust, stability and confidence.

Part 2
RBI and the Safeguarding of Confidence
The series then turns to the RBI’s evolution, its expanding institutional role, and the balance between autonomy, growth and price stability.

Part 3
The Rise and Fall of Monetary Policy Regimes
From Bretton Woods to monetary targeting, the masterclass examines how central banks repeatedly reinvented monetary policy frameworks when old anchors collapsed.

Part 4
When Monetary Anchors Collapse
As monetary targeting broke down globally, central banks were pushed again into uncertainty, instability and regime change.

Part 5
Central Banking and Monetary Policy Regimes: The Indian Experience
How India’s trysts with crises, policy responses and changing gears in the development strategy imposed monetary policy regime shifts upon the RBI.

Part 6
Inflation Targeting and the Contract of Trust
From time inconsistency to flexible mandates, Michael Patra explains how inflation targeting became the world’s most durable monetary policy regime.