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The RBI’s focus on CPI inflation is welcome, but its policy needs to be more predictable.

Published: January 29, 2014 2:18 am

The RBI’s focus on CPI inflation is welcome, but its policy needs to be more predictable.

The RBI has raised the repo rate by 25 basis points in its policy announcement. This is part of a larger mission to move the RBI towards becoming a credible inflation-targeting central bank. When the inflation rate is higher than desired, the credibility of a central bank is at stake if it keeps interest rates low. The Urjit Patel committee had recommended that the RBI target CPI inflation — the variable that people care about.

Governor Raghuram Rajan has indicated that he is studying the committee’s recommendations. But on this point, it seems that the RBI is already making the shift. This is welcome because the average individual is not really affected by wholesale price inflation.

Looking forward, the RBI is likely to adopt the Urjit Patel committee CPI inflation target of 8 per cent (to be achieved by January 2015) regardless of whether it formally adopts the committee report. The difficulty might be if inflation remains stubborn and refuses to go down. Yet, it seems the RBI hopes that inflation will remain low, considering the tightening it has just done and the fiscal contraction expected in the January-March quarter. That is why the RBI seems to be suggesting that this may be the end of the rate-hike cycle in the near term.

The RBI’s policy came as a surprise to market participants. Central bank communication is an important element of monetary policy. Since the repo rate was not hiked last time, participants were surprised because nothing much has changed since, and growth forecasts appear weaker. The lesson for the RBI is that it needs to communicate better and act on what it is signalling. Last time, the signals suggested a rate hike but the governor choose not to increase the repo rate. That is why, this time too, the market expected him to hold rates. However, over time, both will learn how to signal and read signals better.

In countries where an inflation-targeting framework has been in place for a long time, the market understands the central bank’s reaction function so well that it does not wait for the policy statement. The market moves when economic data on employment or inflation comes out, as it can anticipate how the central bank will react. This will take time, but Rajan appears to be slowly and steadily moving towards such a framework.

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