Monetary Policy Committee

The Reserve Bank of India is entrusted with maintaining price stability in the country through its monetary policy tools, such as repo rate and reverse repo rate. The Monetary Policy Committee (MPC) decides policy rates to achieve the inflation target set by the government. The MPC is a six-member body with the RBI Governor as ex officio chairperson. It is constituted by the central government through a notification in the official gazette. The committee meets throughout the year to assess the economic situation and take decisions on policy rates. The MPC is mandated by the government to maintain the Consumer Price Index (CPI) between a 2-6% tolerance band and 4% target inflation. Since its inception in 2016, MPC has largely been successful in maintaining inflation within the inflation target range, except for the pandemic period. But in recent years, economists have raised a few doubts over the efficacy of inflation targeting in price control. To overcome this, coordination between monetary policy and fiscal policy is necessary. It would not only be more effective in price control but also ensure a balance between growth and inflation.

Before the constitution of the MPC, the policy rates were decided by the RBI Governor alone. The RBI Governor was advised by a Technical Advisory Committee (TAC), which consisted of experts from monetary economics, financial markets, public finance, and central banking. But, this mechanism did not instil confidence in stability in the market, as the RBI Governor was appointed and removed at any time by the central government. So if there was any tussle between the RBI and the government, uncertainty regarding rates would change. It was also felt that too much decision-making power was vested in one person, the governor. Various committees, over the years, suggested the constitution of a monetary policy committee that would be responsible for monetary policy. These committees were:

• YV Reddy Committee (2002)
• Tarapore Committee (2006)
• Percy Mistry Committee (2007)
• Raghuram Rajan Committee (2009)

• Finally, in 2014, the Urjit Patel Committee also recommended the formation of a MPC. On the basis of these recommendations, MPC was formed.

The MPC is required to meet at least four times a year. Decisions taken by the committee are taken by a majority. Each member of the committee has one vote, and the Governor has a casting vote in case of a tie. Each member of the MPC is entitled to write a statement specifying the rationale for voting for or against the proposed resolution. The minutes of the meetings are also published.

It is a six-member body (3 ex-officio and 3 nominated):

• Governor of RBI, ex-officio, Chairperson
• Deputy Governor of RBI, in charge of Monetary Affairs, ex-officio
• One officer of the RBI nominated by the Central Board, ex-officio
• Three other members, nominated by the central government for a period of 4 years or until further order (whichever is earlier)

• This framework was introduced by amending the RBI Act of 1934.
• Section 45ZB of the RBI Act provides for the constitution of the MPC to decide the policy rates to control inflation.
• Under Section 45ZA, the central government decides the inflation target once every five years in consultation with the RBI.
  • The central government has set the inflation target of the CPI at 4% with a tolerance band of 2-6% for the five-year period of April 1, 2021, to March 31, 2026. This inflation target is reviewed every five years.

The central government has mentioned some factors that would constitute a failure to maintain the inflation target through a notification. These factors are:

1. The average inflation is more than the upper tolerance level (of 6%) for three consecutive quarters or
2. The average inflation is less than the lower tolerance level (of 2%) for three consecutive quarters.

In case of failure to maintain the inflation target, the RBI shall report to the central government, enumerating the following:

• The reasons for failure to maintain the inflation target
• Remedial actions proposed to be taken by the RBI
• An estimation of the time it will take to achieve the inflation target after the remedial actions are implemented

The RBI publishes this report every six months to enumerate the following

• An explanation of the inflation dynamics in the last six months and also the near term outlook of inflation.
• Projections of growth and inflation
• A comprehensive assessment of the state of the economy in the country encompasses all the factors that have an impact on monetary policy decisions, such as financial markets and stability, fiscal situation, external sector, etc.
• A review of the operating procedures of MPC.

The RBI and MPC are mandated to target inflation (known as Flexible Inflation Targeting Framework) to achieve the primary objective of maintaining price stability without compromising growth. Inflation targeting is an approach in which the central bank adjusts the policy rates and takes other liquidity measures to keep inflation within the tolerance band. For example, if the headline inflation in the economy is above the threshold, then the RBI may increase the repo rate to bring down the inflation.

• A direct correlation has been observed between market demand and price levels in the economy. Hence, it is a prudent strategy to target inflation, which will ensure price stability and maintain healthy demand in the economy.
• The inflation targeting approach brings more transparency to monetary policy as the inflation data is available to all for contemplation. In addition to this, the MPC minutes of the meeting also provide clarity on the central bank’s stance on rates.
• Simpler to understand for the common man and the private sector. As the change in rate affects all the residents of the country, a simpler monetary policy based on inflation targeting is important.
• In India’s case, the inflation targeting since 2016 has shown some impressive results. The RBI was able to bring down inflation through a subsequent rate increase when inflation was high. During the pandemic, when there was a demand slump, historic rate cuts also ensured that growth was not compromised.
• Investor confidence in the economy has increased because of a more transparent monetary policy.

• Inflation targeting is more suitable for an economy where inflation is demand driven. However, in India, inflation can be due to supply-side constraints, as observed in the COVID-19 pandemic, when the global supply-chain disruption caused a supply crunch.
• For this approach to be successful, there must be an effective transmission of rates to the consumer. Although the RBI has taken certain measures, such as linking retail loans to external benchmarks, the transmission of monetary policy is still not up to expectation.
• Inflation targeting is heavily dependent on the data provided for inflation. Experts have cast doubt on the efficacy of the data. They argue that the data is often incomplete, inaccurate, and comes with a time lag. This means that the actions taken in response to faulty data may not yield the desired results.
• Economists have argued that the RBI must focus on the broad objectives of maintaining a stable exchange rate, sustainable growth, financial stability, etc. that have a bearing on the economy and should not restrict itself to the narrow objective of inflation targeting.

The Monetary Policy Committee has played an important role in the economy since its inception in 2016. The COVID-19 pandemic brought a plethora of challenges for central banks around the world. The developed economies around the world suffered from high inflation due to the after effects of the pandemic, but India did not witness any prolonged periods of high inflation due to the proactive decision making of the MPC. The MPC managed inflation responsibly while supporting growth that put India on the growth trajectory. So far, the inflation-targeting regime has proven largely successful for India. But there are some associated challenges with this regime that can threaten India’s growth prospects in the long term. The RBI’s monetary policy has its limits. Growth and inflation in the economy are inherently tied to the fiscal policy followed by the government. Hence, to maintain balance between growth and inflation, coordination between monetary policy and fiscal policy coupled with economic sector reforms is the need of the hour.