The most sound reform measure of the budget was the agreement between the government and the RBI to facilitate the proposed inflation targeting monetary policy regime in India. Details of the agreement will be finalized only in stages as inflation targeting requires the government to follow a disciplinary fiscal policy and giving more power to the RBI. Besides, the proposed RBI dominated Monetary Policy Committee is also government’s ratification.
The agreement announced through the budget is a very important one given the history of central bank-government relationship in the past. During the pre-reform period, the RBI had not freedom, rather was just giving the loans requested by the government. In the last one decade, the RBI was compelled many times by the Finance Ministry to cut interest rates. The famous walk alone statement by P Chidambaram is a classic example for the voice of difference between the two economic managers.
Inflation in India is moving in accordance with economic events like increasing food availability from government subsidy programmes and crude price movements. But RBI is claiming victory for its demand management activities.
The ultimate question is whether inflation targeting is capable of improving price stability in India. The answer is that its contribution will be marginal and not substantial. This is the conclusion we should reach after studying many advanced developing economies who have introduced inflation targeting and at the same time fitting it in the Indian environment. What inflation targeting will bring in India is more operational freedom to the central bank and nothing more than that.
At the same time, one future development should be read along with the launch of inflation targeting in India. It is that the price situation in the country is undergoing some structural shift. The key driving force of price level- food has shown improved supply elasticity. Anybody can observe that food grain price has come down and government has established a big food subsidy regime which will make food grains at stable prices in the long run. Similarly, in the immediate future or in five years, protein items may also show increased elasticity with commercialization. In this context the supply shortage driven food inflation in the country itself may ensure price stability.
But this price stability success may be claimed by the new inflation targeting regime. At present, many ‘lauding class’ pundits are giving credit for the present low inflation to the RBI, rather than highlighting declining food and oil prices. This means that in future, when supply forces are developed to ensure expanding supply and stable prices, the RBI and the inflation targeting may take claims. A situation of ‘the King at the palace taking the credit for victory in the war’ led by the general becomes unavoidable.
It is to be noted that launch of inflation targeting requires more commitments from the government than from the RBI. On its behalf, the government should contain fiscal deficit to help the RBI to achieve the set inflation target. Similarly, at present, the public debt office of the government is with the RBI. The occasional lending by the RBI to the government to adjust cash flows also will be restricted with the new regime.
Another adjustment will be the timing of government’s borrowing programme. It will be in accordance with the RBI’s expectations of price movements.
Most importantly, the RBI should be given more autonomy, (though not to the extent of the Bank of England) to execute monetary policy decisions. Of course, the next stop for the RBI is the autonomy it may seek from the government.