RBI Urjit Patel Committee_ 4% CPI, Nominal Anchor, Multiple Indicator, Monetary Policy Framework...

8/13/2019 RBI Urjit Patel Committee_ 4% CPI, Nominal Anchor, Multiple Indicator, Monetary Policy Framework Reforms (Part 1 of 2) Print

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[Economy] RBI Urjit Patel Committee: 4% CPI, Nominal Anchor, MultipleIndicator, Monetary Policy Framework Reforms (Part 1 of 2)

1. Prologue2. Monetary Policy: Where to focus?

1. #1: Focus on Exchange rate2. #2: Focus on Multiple indicators3. #3: focus on inflation

1. Nominal anchor (CPI) method: Benefits/Advantages of 2. Nominal anchor (CPI) method: Drawbacks/Limitations/Anti-arguments

3. Why Target inflation?1. Nominal vs Real interest rate2. Nominal Anchor (CPI): the 4% Target3. Nominal Anchor CPI 4%: WHEN to reach?4. Nominal Anchor CPI 4%: How to reach?

4. Hawkish trend: Why interest rate s will rise?5. Mock Questions

Pro logue

This article wo nt make much sense, unless youre thorough with the concepts of monetary policy: its functions, too ls and limitation. So make sure youve read the previous article. click

me.Place : RBIs Main Adda @MumbaiTime : September 2013Boss : Rajan has recently taken charge as the new governor of RBI. Immediately hesetups three Committees:
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcoming-urjit-article.htmlhttp://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcoming-urjit-article.htmlhttp://-/?-http://-/?-http://-/?-http://-/?-http://-/?-http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcoming-urjit-article.htmlhttp://-/?-http://-/?-http://-/?-http://-/?-http://-/?-http://-/?-http://-/?-http://mrunal.org/


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ChairmanOccupationin RBI

Topic Result

BimalJalan

RetireGovernor New Bank licenses Work in progress.

NachiketMor

Boardmember

Financial products/ Financialinclusion

Published report in January 2014.

Discussed in earlier articles.

UrjitPatel

DeputyGovernor

Monetary policy framework:how to strengthen it?

Published report in Jan14. This isthe topic of our article.

Urjit Patel Committee: Basics

1. Formed by : RBI (and not finance ministry)2. Official name: Expert Committee to Revise and Strengthen the Monetary Policy

Framework 3. Chairman : Dr. Urjit Patel, Dy. Governor of RBI4. Eight Members : economics professors, finance experts etc. Theyre not important for

exams, because No high profile members. [may be because Nachiket took away all thehigh profile members like Shikha Sharma of Axis bank , so Urjit bhai was left with onlychillar parties.]

Overall, Urjit Patels main recommendations can be summarized in just three lines:
http://mrunal.org/2014/01/banking-nachiket-panel-universal-electronic-banking-account-ueba-payment-access-points-financial-inclusion-seigniorage-and-more.html#1http://mrunal.org/2014/01/banking-nachiket-panel-universal-electronic-banking-account-ueba-payment-access-points-financial-inclusion-seigniorage-and-more.htmlhttp://www.flickr.com/photos/97816112@N02/12268369415/


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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.]

Lets start with first recommendation.

Urjit

My first recommendation is that RBI must target inflation only. Nothing else- dontfocus on increasing employment, dont focus on increasing growth, dont focus onstabilizing rupee-dollar exchange rate. Just focus on one thing and one thing only-Inflation.

Mohan But why focus on inflation only?Urjit Observe.

Monetary Policy: Where to focus?
http://www.flickr.com/photos/97816112@N02/12268813404/


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There are three main ways to frame monetary policy

1. Focus on Exchange Rate2. Focus Multiple indicator (GDP, IIP, Exchange rate, inflation)3. Focus on Inflation (started in 80s)

Lets check the pros and cons of each strategy.

#1: Focus on Exchange rate

If RBI adopts this strategy/method to frame monetary policy then- what will happen?Rajan will first decide an ideal target exchange rate say 1$=Rs.50.Then hell try to amend monetary policy to control rupee supply in the market.

To put this in technically incorrect example: Imagine dollars are apples.

Prices of apple vs Rupee are decided by laws of supply and demand.At present 1 apple sells for Rs.60. But Rajan wants to bring it 1 Apple=50 rupees. Whatshould he do?

1. Rajan will tweak his monetary policy to reduce the supply of rupee in the market. Then,


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#2: Focus on Multiple indicators

At present, this is the strategy RBI uses for making monetary policy.

Under multiple indicator method, Rajan will first gather information about:

1. Index of industrial production (IIP), Consumer confidence2. Professional forecasts (CRISIL, S&P, Moody, World Bank) about GDP, inflation,

unemployment3. Inflation data: WPI minus food, fuel.

Then, he will design the monetary policy (mainly repo rate), with followingobjectives/focuses:

1. Increase employment2. Increase GDP3. Stabilize inflation4. Stabilize exchange rate

Sounds fair enough? Not really!

Multiple indicator method: Negative points/ Limitations

1. Multiple indictor method has no nominal anchor- no actual target. What exactly areyou trying to accomplish? Bring down WPI by 5%, raise GDP to 9%..no such targets.Just bol-bachhan. Therefore ineffective.

2. Multiple indicator strategy worked well between 1998 and 2008. GDP was good andinflation was kept in check. But in recent times, this strategy is no longer working-inflation has skyrocketed and GDP is falling day by day.

3. Since 2008, Consumer price index rose to double digits (i.e. 10% or more)4. But RBI doesnt focus on CPI. They only focus on WPI (minus food and fuel). Result?a. WPI doesnt track changes in the service sector related inflation (e.g. doctor,

physiotherapist, IT, call center etc.) b. Service sector contributes more than 60% of GDP. So, when monetary policy is

designed without considering service sector inflation=then itll be ineffective.5. WPI commodity list has been revised in recent times- they added ice cream, oven,

cricket ball, guitar and so on. Result?a. 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 GDPetc.

b. But when WPI commodity list is revised, RBI has to calculate new statistical projections= problem. Policy doesnt 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 adeveloping country, the past article. Click me

7. Since this strategy doesnt have a clear cut transparent targets, it becomes vulnerable tovarious pressure groups. For example

Pressuregroup

informally forces Rajan to:
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcoming-urjit-article.html#991


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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 toincrease employment- after all thats what you want- increaseemployment!Secondly, please increase the quota for women under Priority sector lending because Rahul baba has been advocating women empowermenteverywhere, including @Arnab Goswamis interview.

Exporters/ITcompanies

Rajan Bhai, please tweak your monetary policy in such way that$1=becomes 1000 rupees, then we earn more rupees while exportinggoods n services abroad.

ImportersPlease design your monetary policy in such way that $1 = Rs.1. thenweve to spend less rupees while importing stuff from abroad.

FICCIPlease decrease Priority sector lending, CRR and SLR that way moremoney is left for business loans for corporate giants.

Bankers Maai baap , please reduce PSL targets, SLR, CRR and Repo, that waymore money is left with us, and we can lend it to middle class and

businessmen.

Therefore, Urjit recommends Rajan to dump this multiple indicator method.

Mohan

Ok boss. So far Ive learned following:

1. Monetary policy should not focus on exchange rate because our country isvery large, unlike Singapore and Taiwan.

2. Monetary policy should not focus on multiple indicator approach, becauseof the limitations we just saw in above paragraph.

Then what is your solution?

Urjit Simple. Focus on inflation

#3: focus on inflationIn this strategy- Rajan will decide a Nominal Anchor say CPI -to monitor inflation. Thenhell fix an inflation-target say 2-6% and adjust his monetary policy so that inflation remainswithin that range.

Nominal anchor (CPI) method: Benefits/Advantages of

1. Once Rajan sets a CPI target. Noone can influence him or put informal pressure- be itChindu, Exporters, Importers, FICCI, Mallya, Ambani or Bankers cannot influenceRajans policy. Because Rajan


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Urjit Because we are not a developed country, we are a developing country.Weve already learned this limitation of monetary policy in developingcountries. Click me.

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, startsdistributing 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=Rajans 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.

Why Target inflation?

Mohan Im still not clear. Why should Rajan only focus on inflation (CPI). Other things arealso important like GDP, IIP, employment, investment, exchange rates. why focuson CPI only, and ignore everything else?

Urjit let me explain:

petrol and onion prices, hardship to middleclass= those are clichd points. Lets learn somenew points.

In recent years, Indias inflation has been highest among all G20 countries.Indias inflation has been higher than its trade competitors.

CPI 2008 2012World 4 4


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Brazil 5 5China 6 10S.Africa 11 6Russia 14 5

From above table, you can see that

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 moregold=>CAD=>rupee weaken=>petrol expensive=>everything expensive=>every moreinflation =vicious cycle.

Mohan Whoa, whoa, whoa man slow down. What is real interest rate? How does it affecteconomy?

Nominal vs Real interest rate

Urjit Suppose Ive 100 rupees. But instead of buying onions, I put this money in a savingsaccount.

Observe what happens with my purchasing power:

Onion Rs./kg Money How much can you Buy?1st Jan 20 100 5 kg31st Dec 100 104 ~1 kg

Meaning, although bank increased your money from Rs.100 to 104, but you can buy very lessonions. Therefore, we must not focus on nominal interest rate i.e. 4% but on real interest rate.

Bank depositNominal InterestRate

CPI(Inflation)

Real Rate of Interest=(Nominal-Inflation)

Savingsaccount

4.00% 11% -7%

Fixeddeposit

9.00% 11% -2%

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:

Excessive gold import=>Current account deficit increased=>Rupee Weaken=>Petrol/diesel expensive=>even more inflation. This becomes a vicious cycle whereyou cannot find whether hen came first or the egg came first?When people invest money in gold, instead of putting it in bank=> businessmen get lessloans=>less expansion =>less jobs=> less growth in GDP.


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Now if you compare India vs [China, Russia, South Africa]. You can see- their inflationis low=> real interest rate would be higher => people invest less in gold=> moremoney flows towards banks=>business loans=>higher GDP, higher IIP (index of industrial production).

Urjit In other words, when Rajan frames monetary policy, he should only fight againstinflation then low GDP, low IIP will be fixed automatically.Mohan fair enough.

Nominal Anchor (CPI): the 4% Target

Ok far weve learned:

When Rajan frames monetary policy

1. He must focus on fighting inflation only.2. To fight inflation, he must focus on CPI.

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 shouldreduce 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 productioncosts, by firing some of the employees= less new jobs created= unemployment = socialunrest.If prices of everything fall- then custom duty, VAT, excise duty, service tax- their


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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 Minimum 2% inflation is necessary in any economy.Mohan Then what should be the maximum limit for inflation/CPI?

UrjitIve analyzed data from various countries. When CPI gets higher than 6.2%, itnegatively affects GDP and employment. Therefore Rajan should ensure CPIinflation doesnt cross more than 6%.

Mohan Ok, minimum 2% and maximum 6%.

Urjit

Right RBI should try to get CPI inflation @4% wi th band of +/-2% .

meaning 4-2=2% minimumand 4+2=6% maximum

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

thats why 2-6% target.

Besides, the RBIs of other countries also use similar band method: observe

Central Bank of CPI target under their monetary policyMexico 2-4%South Africa 3-6%Israel 1-3%Chile 2-4%

So, its a tried and tested method. we should follow the same.

Nominal Anchor CPI 4%: WHEN to reach?

Mohan

Ok so far Ive learned:

Urjit Patel Committee wants to strengthen monetary policy framework You insist RBI to fight inflation only.You even gave Rajan a target: 4% CPI (Combined), with +/-2% band

Urjit That is correct.

Mohanwell, Your recommendation is ambitious, but unrealistic. I repeat again- There aremany factors outside Rajans control like monsoon and black marketers. I dontthink Rajan can ever bring down inflation to 4% level.

Urjit It is possible. Let me give you the case study of Chile.


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Then Just try to maintain inflation within the 2-6% range. (i.e.4% with +/-2% band)

In short: 0/12/24 (months)=>10/8/6 (CPI)

Nominal Anchor CPI 4%: How to reach?

Mohan Alright. If Chile can do it, we can also do it. But HOW?

UrjitUsing the same tools available in the present monetary policy framework.Especially the policy rate.

Mohan What is policy rate?Urjit Repo rate under Liquidity adjustment facility (LAF)= thats our 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 inextreme situation) because unpredictable policy making= not good for

banking sectors own business plans and tactical projections .

Hawkish trend: Why interest rates will rise?

Mohan

Ok so far Ive learned:

Urjit Patel Committee wants to strengthen monetary policy framework You insist RBI to fight inflation only.You even gave Rajan a target: 4% CPI (Combined), with +/-2% band

You even gave Rajan a timeframe: 0/12/24 (months)=>10/8/6 (CPI)You even gave Rajan the firing strategy: fight inflation via Policy rate(Repo Rate)

Urjit That is correct.

MohanBut then whats the new story my friend? All these years, RBI has tried to fightinflation 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?

UrjitSwami Vivekanand has said Aim higher. On the same logic, I recommend RepoRate should be kept higher than CPI. Then itll fix the problem.


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Observe.

At presentRepo 8%CPI ~10%Difference (Repo MINUS CPI) -2

You can see Repo rate is lower than CPI. Thats why its ineffective. In the previous article onmonetary policy, we learned that

Monetary policy Tool How to Fight inflation? How to fight deflation?Repo rate Increase repo rate Decrease repo rate.

Therefore, to fight inflation repo rate MUST be increased. Urjit Patel recommends that Reporate should be increased so much that its higher than CPI.

At

presentUrjit Patels recommendation

Repo 8% Should be higher than CPI. Here CPI=10, so lets keep Repo@11%CPI ~10% ~10Difference

(Repo MINUSCPI)

-2 (11-10)=+1

In other words, Urjit Patel recommends that difference between Policy rate (Repo rate) andCPI should be positive, Only then Policy rate can fight inflation.

What wi ll be the consequences of high repo rate?

Banks borrow less from RBI (Because theyve to pay more interest rate)Banks will increase their loan interest rates (because theyve less new money and stillwant to keep profit margin same)Less business expansion (because less people take loans, due to higher interest rate)Less new jobs createdLess income

Less demandSellers will reduce Prices of goods and services, to attract and retain customers.=inflation reduced.

Mohan Wait wait wait. Urjit Patel, youre a hawkish person, a person who believesinflation can be fought by increasing the interest rates.Urjit So what?

So manRajan raises Repo rate=>SBI increases loan interest rates=>harder to borrow for businessmen=>less business expansion =>less new


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Mohan jobs=>deflationary trend=>this will hurt our GDP.CRISIL, Moody and other experts have made statistical projections- that evenin 2015, our CPI will be ~8.5%. So by your logic, Rajan should keep Repo@9%. It will kill the growth!

Urjit

Theoretically youre 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, Israelall have taken same measure in past.When inflation became very high, they raised repo rate to level higher thaninflation. Only then problem was fixed.

MohanWhatever man. Im going to write a column in TheH**** to criticize you that If Urjit Patel Committees 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:1. @RBI fight inflation

a. Target =4% CPI, +/-2% Band [=control inflation in 2-6% range.] b. Tool =Repo as policy rate, +/-1% spread in RR-Repo-MSF,c. Time l imit : 0/12/24 (months)=10/8/6% (CPI)d. Strategy =keep repo higher than CPI.

2. @Chindu, give cover fire to Rajan, while he is fighting inflation (=in next article)3. @Rajan fix accountability in your gang. (=in next article)


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Mock Questions

1. Incorrect statementa. Nominal interest rate doesnt take inflation into account.

b. Real interest rate doesnt take Nominal interest rate into account.c. Both A and Bd. Neither A nor B

2. What do you understand by Real interest rate?a. Nominal interest rate plus inflation

b. Nominal interest rate minus inflationc. Nominal interest rate multiplied with inflationd. None of above.

3. In a futuri stic society, if Real i nterest rate became a posi tive number, which of the fol lowing is most li kely to be correct?

a. Fiscal deficit increased at the expense of current account deficit. b. People have started putting their entire savings into gold.c. RBI and Government failed in combating inflation.d. RBI and government successfully managed to bring down inflation below the

nominal interest offered in banks.4. Urjit Patel Committee has observed that

a. CPI lower than 2% is good for economy but CPI higher than 6% is bad for


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economy b. CPI lower than 2% facilitates growth but CPI higher than 6% reduces

employment.c. CPI lower than 2% and higher than 6%, are bad for GDP and employment.d. None of above.

5. Urjit Patel Committee has recommended thata. RBI should continue with multiple indicator method to frame monetary policy,

while targeting 4% inflation. b. RBI should ignore fuel, food and service sector inflation and focus on core

inflation only.c. RBI should frame monetary policy while keeping CPI as the nominal anchor.d. None of above.

6. Urjit Patel recommends RBI to:a. Bring down consumer price index inflation to 6% within next twelve months.

b. Switch its focus from multiple indicators to exchange rate stabilizationc. both A and Bd. Neither A nor B.

7. To Combat inflation, Urjit Patel Committee has recommended RBI to:

a. Keep Repo rate lower than CPI. b. Keep Reverse repo rate higher than MSF.c. Keep the value of Reverse repo rate between Repo rate and MSF.d. None of Above.

Q8. If RBI frames monetary pol icy wi th primary objective of stabil izing the exchangerate, what will be the consequences?

1. Country becomes vulnerable to shocks emanating from the country to which itscurrency is pegged.

2. Country becomes immune to speculative attacks in forex trading market.3. Imported inflation will be kept in check.

Choices

a. Only 1 and 2 b. Only 2 and 3c. Only 1 and 3d. All 1, 2 and 3.

Q9. What are the recommendations of Urjit Patel Committee?

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

a. Only 1 and 2 b. Only 2 and 3c. Only 1 and 3


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d. Only 1

Q10. Match the following:

I. Hawk 1. Purchases securities under the assumption that they can be sold later at ahigher price.

II. Bull 2. Believes that a particular stock or the market as a whole, is headed for afall in prices.

III. 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 choicesOptions I II IIIA 1 2 3B 4 1 2C 3 1 2D 3 2 1

Q11. Match following

I. Nachiket Mor 1. Nominal Anchor Method to frame Monetary Policy

II. Urjit Patel 2. Financial Sector Legislative Reforms

III. BN SriKrishna 3. Governance of Boards of Banks in India.

IV. P. J. Nayak 4. Financial products for small businessmen.

5. State backwardness index

Answer choices

Options I II III IVA 5 1 2 3B 3 1 3 5C 4 1 2 5


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D 4 1 2 3

Mains / interview type questions, once we finish remaining recommendations of thecommittee in next article.

MCQ hints:

1. incorrect statement is B

2. technical formula is bit different- but here opt B3. last one4. 6 both bad.5. second last6. neither 7. none8. second statement is wrong.9. only first statement is right

10. hawk-interest, bull -will rise; bears-will fall11. Nachi- products, Urjit- Nominal, BN-reforms, Nayak-Board.

Visit Mrunal.org/Economy For more on Money, Banking, Finance, Taxation and Economy.

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