RBI formally adopted a Nominal Anchor for Monetary Policy on the 28th of January 2014 when it raised the benchmark policy rate, the Repo Rate, by 25bps from 7.75% to 8%. The central bank based its policy decisions on the back of a formal target for CPI (Consumer Price Index) inflation of 8% and 6% by January 2015 and January 2016 respectively.
The Nominal Anchor for Monetary Policy is defined as a single variable or device which the central bank uses to pin down expectations of private agents about the nominal price level or its path or about what the Bank might do with respect to achieving that path (Krugman, 2003).
RBI has adopted targeting the CPI as its single policy objective going forward. In adopting the CPI target the RBI is moving away from its multiple indicator approach that was used for setting monetary policy. The multiple indicator approach took into account variables such as money, credit, output, trade, capital flows and fiscal position as well as rate variables such as interest rates, inflation rates and exchange rates (Dr Urjit Patel Committee Report on Revision and Strengthening of India’s Monetary Policy Framework – 21st January 2014).
What will Inflation Targeting mean for India going forward?
Inflation targeting by the RBI would force the central bank to adopt counter-cyclical measures to inflationary government policies. For example if a government is intent on borrowing and spending money to push up growth in the economy, the RBI would have to negate the inflationary impact of fiscal imprudence through tight monetary policy measures.
Inflation targeting could result in a prolonged slow pace of economic growth. India is growing at decade low growth rates of 5% for this fiscal year 2013-14 but CPI inflation is close to double digit levels as of December 2013. RBI by raising policy rates to lower inflation expectations is effectively keeping interest rates high in the economy and this is seen as detrimental to economic growth. However in the long term, low inflation expectations is the key for sustainable growth.
How will the markets behave on RBI’s inflation targeting approach?
Bond markets in the short run will always react negatively (positively) to policy rate hikes (cuts). The reason is that rate hikes (cuts) affect cost of funds for the market participants. In the longer period, factors such as long term inflation expectations, government borrowing, liquidity and capital flows would affect bond yields.
The currency markets will move on current account deficit, capital flows and global risk aversion and these factors will in turn be determined by economic growth and long term inflation expectations.Equity markets largely move on corporate earnings that are determined in part by growth-inflation dynamics and in part by technology and innovation. RBI policy rates while having a temporary impact on equity markets would not be the major determinant of equity valuations.