The perils of RBI’s fixation on inflation

Economic Affairs Inflation

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Retail inflation climbed to a six-year high of 7.35 per cent breaching the Reserve Bank of India’s upper band of 6 per cent for the first time since the Monetary Policy Committee was created.

Reserve Bank of India (RBI)- India’s Cental Bank:

Reserve Bank of India (RBI) is the highest monetary authority of India.
RBI was established in 1935 by the RBI Act 1934.
RBI works as a custodian of foreign reserve, banker’s bank, banker to the government of India and controller of credit.

Role and Functions of RBI:

The central bank issues and regulates currency notes. It keeps reserves with a view to securing monetary stability and is called banker to banks. It regulates and supervise banks and other financial institutions. The RBI plays a vital role in economic growth of the country and maintaining price stability.
Monetary Policy of the country: The RBI has been tasked to have a modern monetary policy framework to meet the challenges of an increasingly complex economy and to maintain price stability while keeping in mind the objective of growth.
Inflation control: The RBI has targeted to keep the mid-term inflation at 4 four per cent (+/- 2 per cent).
Banker’s Bank: The Reserve Bank performs the same functions for the other commercial banks as the other banks ordinarily perform for their customers. RBI lends money to all the commercial banks of the country.
Controller of the Credit: The RBI undertakes the responsibility of controlling credit created by the commercial banks. When RBI observes that the economy has sufficient money supply and it may cause inflationary situation in the country then it squeezes the money supply through its tight monetary policy and vice versa.
Lender of last resort: To avoid collapse of credit, the central bank was conceived of as the lender of last resort.
Prevention of run on the banks: Lender of last resort is the one that could pre-empt a run on banks and give them time to put their books back in order.
Regulation of banks: However, this was to be accompanied by the adoption of a tough regulatory stance.
Whereby the central bank would stay hawk-eyed towards the activities of banks, particularly risky lending.

Inflation targeting and regulation of the financial market by RBI:

Multiple indicator approach: In India, the RBI had earlier pursued a ‘multiple indicators approach’. The approach involves concern for outcomes other than inflation, including even the balance of payments.

Favouring low inflation over lower unemployment: Discouraging the ‘multiple indicator approach’ encouraged low inflation over low unemployment.
Inflation targeting as the sole objective of monetary policy: The Indian government also instituted inflation targeting as the sole objective of monetary policy.
The fixed target for the RBI: The RBI was permitted to exceed or fall short of a targeted inflation rate of 4% by a margin of 2 percentage points.

Monetary Policy Framework The Government of India and Reserve Bank of India signed a Monetary Policy Framework Agreement in 2015.The objective of monetary policy framework is to primarily maintain price stability, while keeping in mind the objective of growth.As per the agreement, RBI would set the policy interest rates and would aim to bring inflation below 6 per cent by January 2016 and within 4 per cent with a band of (+/-) 2 per cent for 2016-17 and all subsequent years. Monetary Policy Committee (MPC): Monetary Policy is announced by MPC which has been setup based on recommendations of Urjit Patel committee.MPC consist of six members, 3 from RBI and 3 appointed by the Government.Members from RBI are governor of RBI, a deputy governor and one officer of RBI.Members from government are appointed on the recommendations of a search cum selection committee headed by cabinet secretary.

Consequences of shifting roles of RBI

IL&FS crisis: In 2018, within three years of the adoption of inflation targeting goal, a crisis engulfed IL&FS, a non-banking financial company in the infrastructure space.
IL&FS is not just another ‘shadow bank’, it operated over 100 subsidiaries and was sitting on a debt of ?94,000 crores.
Effects of default: Given this, IL&FS default had a chilling effect on the investors, banks and mutual funds associated with it both directly or indirectly.
PMC bank crisis: In 2019, a run on the Punjab and Maharashtra Co-operative Bank had to be averted by imposing withdrawal limits.
Outright fraud in PMC case: While in the case of IL&FS, some part of the problem may have been caused by a slowing economy, outright fraud underlay the crisis at PMC Bank.
Raghavendra Sahakara Bank case: In early 2020, curbs have had to be placed on withdrawals from the Bengaluru-based Sri Guru Raghavendra Sahakara Bank.

The recent rise in inflation and shortfall of currency notes:

Inflation at 7%: At over 7%, the inflation rate in December is the highest in five years. This may not be the reason to panic, for the price rise could be seasonal and may well abate. But it does raise a question on the efficacy of inflation targeting as a means of inflation control.
If the inflation rate was within the intended range so far, that may have been due to both declining food prices and, for a phase, oil prices.
The shortfall of notes: The central bank has a monopoly on the issue of notes.
There is an absolute shortage of small denomination notes in the bazaars of India.
Small-denomination notes are mostly unavailable.

Conclusion:

The establishment of some of the world’s oldest central banks was inspired by the goal of maintaining financial stability. Central Banks emerged as lender of last resort accompanied by tough regulatory oversight powers over banking system

However, with the rise of neoliberalism whereby markets should be given free play, the regulatory role of central banks took a back seat. They came to be primarily mandated with inflation control. While focusing on the inflation, the Central bank also needs to keep the other mandates especially the regulation of the finance sector in check.

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