New Framework for Monetary Policy

Published: 24th Dec, 2020

Since 2016 India’s moderate policy framework underwent a change and a new framework described as flexible inflation targeting (FIT) was instituted. Under this framework the primary objective of monetary policy is to achieve an inflation rate of 4 %, while keeping in mind the objective of growth.
The inflation rate is defined as year on year changes (in percentage) in the consumer price index (CPI). In view of the fact that the Indian economy is subjected to frequent supply shocks, a tolerance band has been prescribed around the inflation target of 4 percent.
A lower tolerance limit is set at 2 percent and an upper tolerance limit is at 6 percent. The target and the tolerance limits are specified by the GOI providing an example of monetary-fiscal coordination as the GOI and the RBI then share a joint responsibility in setting achieving the goals of monetary policy.
The CPI measures prices paid by consumers at the retail level. Thus, it captures prices that the common person faces on a regular basis and by doing so, it relates the conduct of monetary policy to everyday life.
For people working in the organized sector, their salaries and wages are ‘indexed’ to the CPI so that whenever the CPI increases by a specified amount, they are given dearness allowance. By keeping CPI inflation at the target, monetary policy contributes to the welfare of the lay person.
It has been ensured that the lay person can easily judge whether or not monetary policy is working for the betterment of the people of India. This is the second important element of FIT transparency.
Under the new framework, clear rules of accountability have been laid out. If there is a continuous deviation of actual inflation from the target’s tolerance bands for three consecutive quarters, the RBI has to write a letter to the GoI explaining the reasons for the deviation, the actions that will be taken to correct the deviations.
So far, it was the Governor of the RBI who was the sole decision-maker in respect of monetary policy actions and stance. Under the new framework, the decision has to be taken by a six-member committee called the Monetary Policy Committee (MPC).
The Governor is the Chairperson, and the Deputy Governor and an office the RBI are appointed as ex-officio internal members of the MPC. Three other members are external, selected by the GoI.
Each member has a single vote, with the Governor exercising a casting vote in the case of a tie. The MPC is required to meet at least once every quarter.