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http://mrunal.org/2014/02/economy-rbi-urjit-patel-committee-4-cpi-nominal-anchor-multiple-indicator-monetary-policy-framework-
reforms-part-1-of-2.html
Prologue
This article won’t make much sense, unless you’re thorough with the concepts of monetary policy: its functions,
tools and limitation. So make sure you’ve read the previous article. click me.
Urjit Patel Deputy Monetary policy framework: how to Published report in Jan’14. This is the topic
Governor strengthen it? of our article.
Overall, Urjit Patel’s main recommendations can be summarized in just three lines:
1. @Rajan, you fight inflation. [Nominal anchor, 4% CPI and everything]
2. @Rajan, you fix accountability in your own gang. [form MPC Committee, decisions by voting etc.]
3. @Chindu, you give cover-fire to Rajan, while he is fighting inflation. [fiscal consolidation.]
Urjit My first recommendation is that RBI must target inflation only. Nothing else- don’t focus on increasing
employment, don’t focus on increasing growth, don’t focus on stabilizing rupee-dollar exchange rate.
Just focus on one thing and one thing only- Inflation.
Urjit Observe.
1. Rajan will tweak his monetary policy to reduce the supply of rupee in the market. Then, 1 apple will sell for
Rs.50. (apple supply is same but rupee supply is decreased.)
2. Alternatively, Rajan will open his own refrigerator (forex reserve), and put some apples (dollars) for sale.
That’ll also bring down prices of 1 apple =50 rupees. (because apple supply increased)
1. Works well for a small countries. Because their population is small, they can even import food from India,
China and just focus on export competitiveness in electronics and consumer goods. e.g. Singapore,
Taiwan etc.
2. But Doesn’t work for large countries like India, Mexico or Brazil. Our population is so large, we cannot
sustain on imported food. We must be self-reliant in food production.
3. Country becomes vulnerable to external shocks. Continuing the previous example of Apple vs Rupee
1. What if American RBI tightens their own monetary policy to control local American inflation (= US
Feds follow a dear money policy =dollar (apple) supply is reduced.)
2. Then Rajan’s statistical projections will go wrong. He’ll have to make new adjustments in Rupee vs
Dollar (Apple) quantity in Indian market.
4. Government is bogus, and causes high food inflation. Result= Real interest rates become negative,
Juntaa will start investing more in gold=>Gold import increased=>payments have to be made in Dollar.
This also creates imbalance in supply-demand of rupee vs Dollars (Apples). Rajan will have hard time
controlling this mess.
5. Country becomes vulnerable to Speculative attacks. e.g. Forex traders in Europe or China decide to hoard
Apples (dollars) in their refrigerator to create artificial shortage in market, so later then can sell their apples
@higher rate. In such speculative attacks, Rajan will have hard time controlling supply-demand of Rupee
vs dollars. He cannot prosecute them under FERA/FEMA laws, those traders live outside his jurisdiction.
6. Outdated: During WW1 era, most central banks used to follow this Exchange rate targeting strategy. But
today, almost all banks in developed countries, have shifted to inflation targeting strategy. Only few
exceptions- like Singapore’s RBI – use this strategy.
Under multiple indicator method, Rajan will first gather information about:
Then, he will design the monetary policy (mainly repo rate), with following objectives/focuses:
1. Increase employment
2. Increase GDP
3. Stabilize inflation
4. Stabilize exchange rate
1. WPI doesn’t track changes in the service sector related inflation (e.g. doctor, physiotherapist, IT, call
center etc.)
2. Service sector contributes more than 60% of GDP. So, when monetary policy is designed without
considering service sector inflation=then it’ll be ineffective.
5. WPI commodity list has been revised in recent times- they added ice cream, oven, cricket ball, guitar and
so on. Result?
1. RBI has to make new statistical calculation about each of such busines arenas- number of people
employed in it, total bank loans given, their contribution to GDP etc.
2. But when WPI commodity list is revised, RBI has to calculate new statistical projections= problem.
Policy doesn’t give effective result in the meantime.
6. Even if Rajan makes best policy, its Impact will be seen after a lag of 3-4 quarters (i.e. nine to twelve
month). Why? We already learned the limitations of Monetary policy in a developing country, the past
article. Click me
7. Since this strategy doesn’t have a clear cut transparent targets, it becomes vulnerable to various pressure
groups. For example
Chindu
Please increase SLR ratio. That way government is able to sell more of its securities to
the banks and- arrange cash from more schemes to increase employment- after all that’s
what you want- increase employment!
Secondly, please increase the quota for women under Priority sector lending because
Rahul baba has been advocating “women empowerment” everywhere, including @Arnab
Goswami’s interview.
Exporters/
IT Rajan Bhai, please tweak your monetary policy in such way that $1=becomes 1000
companies rupees, then we earn more rupees while exporting goods n services abroad.
Importers
Please design your monetary policy in such way that $1 = Rs.1. then we’ve to spend less
rupees while importing stuff from abroad.
FICCI
Please decrease Priority sector lending, CRR and SLR that way more money is left for
business loans for corporate giants.
Bankers
Maai baap, please reduce PSL targets, SLR, CRR and Repo, that way more money is left
with us, and we can lend it to middle class and businessmen.
1. Monetary policy should not focus on exchange rate because our country is very large, unlike
Singapore and Taiwan.
2. Monetary policy should not focus on “multiple indicator” approach, because of the limitations
we just saw in above paragraph.
Previous Committees have also directly/indirectly recommended for this system. For example:
Mohan Hold on a second. You’re trying to paint a very rosy picture. But if Rajan’s monetary policy tries to
control CPI, it’ll have many problems!
Mohan In CPI index- more than 50% weightage is given to food and fuel components.
Food prices= depend on monsoon and blackmarketers. Rajan has absolutely zero control over
this.
Fuel/crude oil prices= depend on external factors and Rupee-Dollar exchange rate. Rajan
doesn’t have sufficient forex reserves to control rupee-dollar exchange rate in the manner he
wants (e.g. 1$=50 rupees and not 1$=60 Rs.)
Urjit
You’re right. But under multiple indicator method, Rajan focuses on WPI (minus food and fuel
inflation).
That’s why his policy has remained ineffective in controlling inflation.Because he always
ignored food and fuel inflation.
Infact, We must focus on CPI – for the very same reason-because it give >50% weightage to
the food and fuel inflation.
Mohan Point taken. But in India, we have three CPIs: Urban, Rural and Combined…if we try to control all
three of them, then…..
Urjit No problem. We must focus only on CPI (Combined). Its data is released @every 12 days. Very easy
to monitor, tracks price movement all over India.
Urjit yaar if you start to find fault in everything ( like a TheH**** columnist), ….then only God can help you.
Fidel Castro and Che Guevara cannot fix India’s inflation problem. This only gets fixed from inside the
RBI!
Mohan But even if Rajan focuses on this Nominal Anchor (CPI), still there will be a lag of 6-8 months before
its impacts are seen.
Urjit Brother, no matter which method we use – there will be lag of 6-8 months before its impact is seen on
inflation @ground level.
Mohan Ok one last obstacle. Governments own policy to fight CPI. For example, whenever prices of sugar,
onion or pulses get very high, the government arbitrarily puts export ban on those commodities, start
importing them from xyz country, starts distributing them @subsidized rates in various cities.
Urjit So?
Mohan So Rajan may be designed his policy to fight CPI using abc statistical projections but at random, the
government will do xyz policy on its own to fight inflation= Rajan’s statistical projections will become
wrong and his monetary policy will become #EPIFAIL.
Urjit For this I recommend better coordination and data sharing between Government of India and RBI,
regarding inflation control.
petrol and onion prices, hardship to middleclass= those are clichéd points. Let’s learn some new points.
In recent years, India’s inflation has been highest among all G20 countries.
India’s inflation has been higher than its trade competitors.
World 4 4
Brazil 5 5
China 6 <3
India 9 >10
S.Africa 11 6
Russia 14 5
Between 2008 to 2012- China, South Africa and Russia have drastically reduced their inflation. Only India
is the #EPICFAIL country where inflation has increased- instead of decreasing!
Higher inflation = real interest rates decreased => makes people buy more gold=>CAD=>rupee
weaken=>petrol expensive=>everything expensive=>every more inflation =vicious cycle.
Mohan Whoa, whoa, whoa man slow down. What is real interest rate? How does it affect economy?
Meaning, although bank increased your money from Rs.100 to 104, but you can buy very less onions. Therefore,
we must not focus on nominal interest rate i.e. 4% but on real interest rate.
Bank deposit Nominal Interest Rate CPI (Inflation) Real Rate of Interest=(Nominal-Inflation)
From above table, you can see Banks in India offer “negative” real interest. Therefore, people prefer to invest in
gold, instead of putting money in bank accounts.
Result:
Now the problem? What should be his exact CPI target? 4%, 5%. 0%, -50%??
Mohan This is easy. Rajan should design monetary policy in such way, that CPI is -50%. If bottle of desi
liquor was sold @100 Rs. in 2010, then in 2014 its price should reduce to Rs.50 only. Then Maujaa hi
Maujaa.
Urjit I hate to break your spirit, but such deflationary trend is not good for economy.
Every business has ‘fixed cost of production’ minimum light bill, phone bill, office rent, staff salary etc. So, if
prices keep falling and falling, then businessman will suffer losses. He has no motivation to expand
business. He wants to cut down his production costs, by firing some of the employees= less new jobs
created= unemployment = social unrest.
If prices of everything fall- then custom duty, VAT, excise duty, service tax- their collection will also
decrease. Then government has less money to spend on education, healthcare, social sector, defense,
law and order = poverty, disease, crime.
Mohan Then what should be the “minimum” target? What should be the lower limit of inflation?
Urjit I’ve analyzed data from various countries. When CPI gets higher than 6.2%, it negatively affects GDP
and employment. Therefore Rajan should ensure CPI inflation doesn’t cross more than 6%.
Urjit Right RBI should try to get CPI inflation @4% with band of +/-2%.
Mohan But why give this 2% band? Why not just say 4% is our target?
Urjit
Because in real life, it is not possible to get inflation controlled @exactly 4% level. There will be
unanticipated price shocks in food and fuel items, wars, famines and natural disasters.
Therefore, Rajan should be given some ‘room’ to accommodate such shocks – that’s why 2-6%
target.
Besides, the RBIs of other countries also use similar ‘band’ method: observe
Central Bank of CPI target under their monetary policy
Mexico 2-4%
Israel 1-3%
Chile 2-4%
So, it’s a tried and tested method. we should follow the same.
Mohan well, Your recommendation is ambitious, but unrealistic. I repeat again- There are many factors
outside Rajan’s control like monsoon and black marketers. I don’t think Rajan can ever bring down
inflation to 4% level.
Urjit
Using the same tools
available in the present
monetary policy framework.
Especially the “policy rate”.
Urjit
And reverse repo(RR) = Repo
– minus 1%;
MSF=Repo +plus 1%
^This system is fine. I
recommend that Rajan should
continue with it.
RBI should not change this +/-
1% spread between RR-
Repo-MSF. (unless in extreme
situation) because
unpredictable policy making=
not good for banking sector’s
own business plans and
tactical projections .
Hawkish trend: Why interest rates will rise?
Mohan But then what’s the new story my friend? All these years, RBI has tried to fight inflation by using Repo
rate as its “policy rate”. But it has failed to yield any positive result. What makes you think repo rate
can fix our inflation problems?
Urjit Swami Vivekanand has said “Aim higher.” On the same logic, I recommend Repo Rate should be
kept higher than CPI. Then it’ll fix the problem.
Observe.
At present
Repo 8%
CPI ~10%
You can see Repo rate is lower than CPI. That’s why its ineffective. In the previous article on monetary policy, we
learned that
Therefore, to fight inflation repo rate MUST be increased. Urjit Patel recommends that Repo rate should be
increased so much that its higher than CPI.
Repo 8% Should be higher than CPI. Here CPI=10, so let’s keep Repo
@11%
CPI ~10% ~10
In other words, Urjit Patel recommends that difference between Policy rate (Repo rate) and CPI should be
“positive”, Only then Policy rate can fight inflation.
Banks borrow less from RBI (Because they’ve to pay more interest rate)
Banks will increase their loan interest rates (because they’ve less new money and still want to keep profit
margin same)
Less business expansion (because less people take loans, due to higher interest rate)
Less new jobs created
Less income
Less demand
Sellers will reduce Prices of goods and services, to attract and retain customers.= inflation reduced.
Mohan Wait wait wait. Urjit Patel, you’re a “hawkish” person, a person who believes inflation can be fought
by increasing the interest rates.
Urjit So what?
Mohan
So man…Rajan raises Repo rate=>SBI increases loan interest rates=>harder to borrow for
businessmen=>less business expansion =>less new jobs=>deflationary trend=>this will hurt
our GDP.
CRISIL, Moody and other experts have made statistical projections- that even in 2015, our CPI
will be ~8.5%. So by your logic, Rajan should keep Repo @9%. It will kill the growth!
Urjit
Theoretically you’re right. High interest rates are not conductive for higher GDP growth.
But Indian inflation has become so high, that extreme steps are necessary.
Besides, the RBIs of Australia, Canada, S.Africa, Mexico, Brazil, Israel…… all have taken
same measure in past.
When inflation became very high, they raised repo rate to level higher than inflation. Only then
problem was fixed.
Mohan Whatever man. I’m going to write a column in TheH**** to criticize you that “ If Urjit Patel Committee’s
report is implemented, interest rates will rise and growth will be killed.” (Packs his laptop and
Prepares to leave.)
Urjit WAIT! Picture abhi baaki hai mere dost. Overall I made three important recommendations. In this
article we only learned the first one:
Mock Questions
1. Incorrect statement
1. CPI lower than 2% is good for economy but CPI higher than 6% is bad for economy
2. CPI lower than 2% facilitates growth but CPI higher than 6% reduces employment.
3. CPI lower than 2% and higher than 6%, are bad for GDP and employment.
4. None of above.
1. RBI should continue with multiple indicator method to frame monetary policy, while targeting 4%
inflation.
2. RBI should ignore fuel, food and service sector inflation and focus on core inflation only.
3. RBI should frame monetary policy while keeping CPI as the nominal anchor.
4. None of above.
1. Bring down consumer price index inflation to 6% within next twelve months.
2. Switch its focus from multiple indicators to exchange rate stabilization
3. both A and B
4. Neither A nor B.
Q8. If RBI frames monetary policy with primary objective of stabilizing the exchange rate, what will be the
consequences?
1. Country becomes vulnerable to shocks emanating from the country to which its currency is pegged.
2. Country becomes immune to speculative attacks in forex trading market.
3. Imported inflation will be kept in check.
Choices
1. Only 1 and 2
2. Only 2 and 3
3. Only 1 and 3
4. All 1, 2 and 3.
1. Ination should be the nominal anchor for the monetary policy framework.
2. RBI should adopt the new CPI (rural) as the measure of the nominal anchor for policy communication.
3. WPI ination should be set at 4 per cent with a band of +/- 2
Answer choices
1. Only 1 and 2
2. Only 2 and 3
3. Only 1 and 3
4. Only 1
1. Hawk 1. Purchases securities under the assumption that they can be sold later at a higher price.
2. Bull 2. Believes that a particular stock or the market as a whole, is headed for a fall in prices.
3. Bear 3. Favors relatively high interest rates in order to keep inflation in check.
–
4. Favors relatively low interest rates in order to keep deflation in check.
Answer choices
Options I II III
A 1 2 3
B 4 1 2
C 3 1 2
D 3 2 1
–
5. State backwardness index
Answer choices
Options I II III IV
A 5 1 2 3
B 3 1 3 5
C 4 1 2 5
D 4 1 2 3
Mains / interview type questions, once we finish remaining recommendations of the committee in next article.
MCQ hints:
1. incorrect statement is B
2. technical formula is bit different- but here opt B
3. last one
4. <2 and >6 both bad.
5. second last
6. neither
7. none
8. second statement is wrong.
9. only first statement is right
10. hawk-interest, bull -will rise; bears-will fall
11. Nachi- products, Urjit- Nominal, BN-reforms, Nayak-Board.
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