Opinion The message is the aim

Considering its exchange rate pegging in the past,it is not enough that the RBI has stopped intervening in the foreign exchange market — it has to communicate its new framework and make a clean break from the framework of exchange rate pegging and multiple objectives. In the past,the RBI has prevented liberalisation of financial markets for both domestic and foreign participants for fear of bringing in capital flows and making it difficult to prevent volatility in the foreign exchange market. Preventing financial markets from developing has not allowed the monetary policy transmission mechanism to strengthen. As a consequence,even when the RBI has been tightening policy over many months,the tightening has not yielded results.

The RBI has to become a central bank that actively seeks to improve the transmission mechanism of monetary policy through developing the bond-currency-derivatives nexus. Once public perception about the RBI changes,the effectiveness of monetary policy in India will improve.

What should the RBI’s next step be,even before the rate hike? First,if inflation control has to be its dharma,the central bank must attempt to get rid of all those functions that might conflict with this objective. In the past,some of these conflicting objectives have come in the way of inflation control. For example,if keeping Indian exports competitive by manipulating the exchange rate had not been an important object of RBI policy,the 2004-2008 period would not have witnessed the build-up of reserves and the consequent increase in liquidity,and inflation might arguably have been quite different. Indeed,the RBI would have preferred an appreciating rupee to keep prices under control.

Similarly,if the RBI did not have the responsibility of being the debt manager of the government and keeping its interest expenditure low,it might have raised interest rates more sharply last year. Even though the RBI has moved to a floating rupee,it has shied away from making a commitment that it will not go back to intervening in the foreign exchange market. The market does not believe that if the rupee hits Rs 40 to a dollar,the RBI will still be wedded to inflation control. It is because of such conflicts with the objective of inflation control that most central banks in advanced economies no longer intervene in foreign exchange markets or act as the government’s debt manager. The RBI cannot build credibility as a central bank focused on inflation if it continues its present stance of arguing that it will continue to have multiple objectives and will somehow manage these objectives when a conflict arises.

Second,the RBI’s communication on inflation needs to change. On the trade-off between growth and inflation,it has often been argued that inflation targeting means that a central bank must ignore all other objectives such as growth in employment. The present policy statement has seen a break from this framework. The RBI has acknowledged that the objective of high growth does not conflict with that of inflation control. Indeed,high and volatile inflation reduces investment by introducing uncertainty and hurts medium- and long-term growth. This analytical framework needs to become the RBI’s main message.

Next,to build credibility,the RBI should state its inflation measure and target. In the present policy it says: “Accordingly,the conduct of monetary policy will continue to condition and contain perceptions of inflation in the range of 4.0-4.5 per cent,with particular focus on the behaviour of the non-food manufacturing component. This will be in line with the medium-term objective of 3.0 per cent inflation consistent with

India’s broader integration into the global economy.”

This is not enough. The RBI needs to state which measure of inflation,such as the one based on the Consumer Price Index,underlies this target. More,few people would find this objective credible. The RBI can gain credibility by presenting how it is faring against this objective in the next policy announcement. A report similar to the Bank of England report and a framework where the governor is questioned by Parliament if he fails to meet his targets would help in bringing credibility to the RBI’s commitment.

Third,better conduct of monetary policy would also require creating a much stronger research capability for measuring inflationary expectations. For example,the present policy statement asserts: “Significantly,the stability of long-term yields,despite the current high rates of inflation,suggests that inflationary expectations remain anchored.” The RBI’s own data on inflationary expectations strongly contradicts this.

Fourth,a short,concise policy statement would be more effective than the present statement which also includes other policy initiatives.

The above are some of the steps that can be taken relatively painlessly in the fight against inflation that could last many quarters. If the RBI is serious about this fight,it needs to start on these urgently.

The writer is a professor at the National Institute of Public Finance and Policy,Delhi