Inflation Targeting and Monetary Policy Committee (MPC) Debates

Inflation Targeting and Monetary Policy Committee (MPC) Debates

Sub: Eco

Sec: Monetary Policy

Repo Rate Debate:

• The repo rate has remained at 6.5% for an extended period, leading to a significant difference of opinion within the Monetary Policy Committee (MPC).
• Arguments for Rate Reduction: Proponents argue that high interest rates hamper investment by making capital more expensive. However, there is no substantial evidence to support this claim, as historical data shows that high rates have not hindered borrowing, nor have extremely low rates boosted borrowing.
• Consumer Price Index (CPI) and Food Products:
  • The CPI is heavily weighted towards food products, which are not significantly influenced by interest rates.
  • There is a suggestion to overhaul the index composition by reducing the weightage of food products, potentially leading to lower headline inflation.
• Core Inflation:
  • Core inflation excludes food and fuel items, and with current core inflation at about 3%, this strengthens the argument for cutting the repo rate.
  • Industry favors lower interest rates and often supports the emphasis on core inflation over headline inflation.
• RBI Governor’s Stance on Headline Inflation:
  • The RBI Governor has clarified that food inflation cannot be ignored, as it can influence core inflation, which in turn affects headline inflation.
  • Globally, central banks generally target headline inflation rather than core inflation.
• Historical Analysis of Core and Non-Core Inflation:
  • Over the last 14 years, the average inflation in India was 5.9%, with core inflation averaging 5.8% and non-core inflation at 6%.
  • Core inflation has been above 4% for 89% of the months and above 5% for 61% of the time. In contrast, food inflation shows more volatility, being below 4% about 31% of the time and above 6% almost half the time.
• Price Volatility:
  • Food inflation is subject to supply shocks, which cause significant price volatility. In contrast, core inflation is more stable, as companies rarely reduce the prices of goods and services.
• Inflation Target and Band:
  • The median value of core inflation is around 5.1%, while non-core inflation is 5.7% and headline inflation is 5.4%.
  • There is a case for revising the inflation target from 4% to around 5% with a narrower band of 100 basis points (bps) instead of the current 200 bps.
  • The current band of 50% on either side of the 4% target is considered wide and difficult to interpret for the markets, suggesting a narrower band could be more effective.