The RBI Monetary Policy Framework: Of rituals and lion tamers

By Ananth Narayan

Over the next few days, the Reserve Bank of India's (RBI) bimonthly monetary policy ritual will play out. Our brightest economic minds – including the six high priests of the Monetary Policy Committee (MPC) - will first hazard where Consumer Price Index (CPI) inflation and GDP growth are headed. Interspersed with mantras such as output gap, exogenous and endogenous factors, core and headline inflation and suchlike, they will then suggest the appropriate policy interest rate action to keep CPI inflation in check, while fostering growth.

If we step back, however, there is much to ponder. Does the MPC framework really work the way one would expect? Are we adequately debating all the critical financial stability issues linked to monetary policy?

Of crystal balls…

Truth is, with 57 percent of CPI directly dependent on food and fuel prices, we should have very little confidence around any 1-year ahead CPI inflation estimates.

In April 2018, for example, the MPC had projected CPI at 4.4 percent for H2 FY19 with an upward bias. As it turned out, inflation averaged 2.5 percent during the period.

Given monetary policy prescriptions are based on projected inflation, the starting point itself is shaky.

…and faith healing

Weak inflation projections are the least of our problems. Let’s now ask a taboo monetary question.

Even if we estimated inflationary risks, say by accurately gauging inflation expectations, are we sure we can control CPI inflation by using policy interest rates?

Here’s how textbook monetary policy works. A hike in policy interest rate increases cost of funds, reduces borrowings, reduces consumption demand backed by borrowings, and hence brings down consumer inflation.

This makes intuitive sense in a borrow-to-spend economy like the US, where CEIC data shows household debt at 66 percent of GDP.

How would it work in a borrow-to-produce economy like India, where household debt is only 11 percent of GDP, and where private non-household debt – i.e., borrowings towards production and investment, rather than consumption – is five times household debt?

Is it possible that interest rates are a net input cost in the Indian context? This existential monetary question is yet to be even acknowledged by economists, let alone addressed.

To bristling monetarists, this is not to suggest – as Erdogan does - that the path to lower inflation is lower interest rates. Far from it. But we do need a far deeper understanding of how monetary policy works in India.

Until then, the MPC process risks being reduced to a ritual based on intense faith, rather than cold logic.

But the framework has worked, hasn’t it?

CPI inflation has come down sharply from 8.60 percent when the current framework was suggested in January 2014, to 2.92 percent now. Should we not give some credit to the framework?

Here is a classic trap that my old professor warned of. Whiskey and soda intoxicate John, gin and soda intoxicate John, vodka and soda intoxicate John, ergo, soda intoxicates John.

As a parallel, low food prices and the framework brought down inflation, low crude oil prices and the framework brought down inflation, favorable external context and the framework brought down inflation, therefore, has the framework brought down inflation?

Beyond these admittedly flippant observations, of course, we need sift through the evidence.

What the evidence suggests

The evidence from research is far from conclusive.

Mishra, Sengupta and Montiel (2016) found that tight monetary policy tends to marginally increase inflation in India.

Chinoy, Kumar and Mishra (2016) found that the disinflation between 2014-16 was largely caused by moderation of inflation expectations and lower food prices. However, there is little to suggest that the new framework is behind lower inflation expectations in India – how many of our producers and consumers are even aware of the policy repo rate?

The monetary framework as the lion tamer

This is not to suggest that the monetary framework is completely flawed. We have to understand the genesis of this framework, and therefore how it could actually work.

Between 2009-2013, our fiscal and external balance steadily worsened. Our monetary policy was then like a deer caught in the headlights – frozen by doubts if it could, or should, address the myriad issues around currency markets, growth, inflation and financial stability.

With monetary authorities confused, it was easy to push for the punch bowl of monetary accommodation. Between April 2012 and May 2013, policy repo rate was brought down from 8.50 percent to 7.25 percent. During FY13, the RBI purchased 30 percent of the net government bond issuance through bond open market operations (OMOs). Finally, the bubble burst in mid-2013, with the fed taper tantrum as the proximate trigger.

The current monetary policy framework of using policy rates to control CPI can perhaps tame the lion that can truly impact financial stability – the government. It promises that if the government does its bit to control food prices and fiscal balance, it will be rewarded with lower interest rates – else, it should beware of the whip of higher rates.

Perhaps the framework goaded the government to controlling food prices the past five years (some would argue too successfully), and the fiscal deficit at least during FY14 – FY17.

If this prognosis is right, we could ignore much of the economist speak around CPI and policy rates, and instead focus on core issues of fiscal balance, food prices, monetary transmission, external balance and macroprudential stability.

The fiscal lion is breaking loose

The fiscal lion is breaking loose, and the lion tamer is so far looking the other way.

Provisional data for FY19 shows that tax collections were 0.9 percent of GDP below revised estimates. Despite that, the government says it kept FY19 fiscal deficit at 3.4 percent of GDP.

For anyone who cares to look, the government has simply avoided paying some of its bills. Under its cash accounting methodology, if a bill isn’t paid, there’s no expenditure to be recognised.

Here are some examples. Food Corporation of India has outstanding debt of Rs 1.96 lakh crore, in lieu of food subsidy due from the government. Various other government owned entities have Rs 0.88 lakh crore of Government of India (GOI) serviced bonds outstanding, in lieu of government payments. The debt of power distribution companies is expected to top Rs 2.6 lakh crore by end FY20.

Much of these hidden items are revenue expenditures, rather than capital investments. If the government keeps its promises of lowering taxes and increasing spending, we risk even higher revenue deficits.

With revenue deficits, we are borrowing off our children, not for them.

The MPC, so far, has not acknowledged any of this.


First, closing our eyes may not be the best way to debate the fiscal question. Second, while the very low CPI inflation gives us much comfort, we need an informed debate around how much fiscal space we really have, in the context of financial stability. We have seen the consequences of simultaneously stretched fiscal and external balances in the past – how do we ensure that this time is different? Third, we need to revive the debate around quality of fiscal spending – the question of keeping revenue deficits under control.

Liquidity management  and transmission

As the government brought down inflation from 2014 onward, the RBI brought down policy repo rates from 8 percent in December 2014 to 6.5 percent in April 2016. However, end borrowing rates for clients barely moved. While there are many reasons behind this, one area that the RBI simply hasn’t grasped is the role of banking liquidity in monetary transmission.

We have argued earlier that banking liquidity surplus/deficit is a powerful adjunct to transmit accommodative/tight monetary policy stance respectively. Dr. Rajan finally acknowledged this in the April 2016 policy, when he agreed to move banking liquidity to neutrality.

But we still need a coherent liquidity framework that ties in with the monetary framework.

In addition, it is unclear how the RBI chooses from amongst the many tools to manage Rupee liquidity. RBI purchased a staggering 67 percent of the net GOI issuance in FY19 to infuse liquidity. Ironically, the 2014 Urjit Patel report lamented the 30 percent of net GOI issuance purchased by RBI in FY13.

As we have also argued separately, we need a framework that helps choose the appropriate instruments to manage liquidity under different circumstances.

The impossible trinity and external balance

Monetary policy and interest rates impact our external balance much more than the current framework acknowledges.

In fact, we would argue that the new monetary policy framework and poor monetary transmission was at least partly responsible for the overvaluation of the Rupee till early 2018, and the sharp rise in open currency exposures in the system.

This is a separate topic by itself – but in essence, we believe that until the monetary framework better incorporates and debates the external sector, it is dangerously incomplete.

Monetary policy, reforms and macroprudential stability

In the Indian context, unfortunately, monetary policy is sometimes expected to play a role in lieu of real reforms, or to mask inadequate macroprudential controls. Consider the current situation around Non-Bank Financial Companies (NBFCs).

There is a trust deficit around NBFCs. The way to eventually address this is to undertake hard reform – improve governance and disclosures, infuse capital, improve financial infrastructure, and conduct strict and independent asset quality reviews. It is convenient for the market to brush these hard steps aside and clamour for monetary easing as the first – and perhaps only – line of defense.

On the flip side, concerns that the financial services ecosystem cannot be trusted to deploy money safely should not come in the way of the RBI easing interest rates and liquidity. Such concerns have to be addressed through robust regulations and supervision, not by withholding monetary responses.


The underpinnings of the MPC framework – inflation control through the use of policy interest rates – may well be articles of faith in the Indian context. However, as a means to control the government – arguably the one entity that can most impact inflation and growth – the framework can have a powerful role to play.

The true debate around monetary policy therefore has to progress beyond CPI and policy rates, to financial stability discussions around fiscal balance, external balance, and health of the financial services ecosystem.

In the current context, we need a richer and more honest debate around the extent and quality of our fiscal balance.

The monetary framework also has to acknowledge and debate its impact on the external sector better.

The framework has not resolved the question of monetary transmission. We need to incorporate a liquidity framework and debate the appropriate liquidity tools to be used under different circumstances.

Finally, monetary action cannot substitute for hard, real reform. On the flip side, inadequate prudential regulations and financial supervision should not come in the way of appropriate monetary action.

Ananth Narayan is Associate Professor-Finance at SPJIMR.