New monetary policy framework of RBI to focus on inflation

According to Nomura, a change in the RBI's monetary policy framework with a focus on CPI inflation as the new nominal anchor would have important macro implications and its success depends on the central bank's commitment and ability to adopt institutional changes after introducing the new regime

The Reserve Bank of India (RBI) has set up a committee under deputy governor Dr Urjit Patel to recommend changes to the monetary policy framework with the objective of making it transparent and predictable. According to Nomura, this may be a move towards price stability or inflation targeting instead of the current multiple-indicator approach.


"A change to the RBI's monetary policy framework with a focus on consumer price index (CPI) inflation as the new nominal anchor would have important macro implications," says Nomura in a research report.


However, for inflation targeting to be successful, certain preconditions have to be in place, the report says. "In particular, this calls for full autonomy to be given to the RBI, strict fiscal discipline by the government and a robust banking system. Evidence shows that most countries built up these conditions gradually after adoption."


India's monetary policy framework has been evolving over the past few decades, consistent with the openness of the economy and with the development of financial markets. In April 1999, the RBI introduced the liquidity adjustment facility (LAF) operating through the repo and the reverse repo rate, resulting in dual policy rates. In 2011, the weighted average overnight call money rate was recognized as the operating target of monetary policy and the repo rate was made the sole policy rate. However, the RBI’s liquidity tightening measures – in response to exchange rate depreciation in mid-2013 – made the marginal standing facility (MSF) rate the effective policy rate, diluting the role of the repo rate since then.


The RBI has historically followed a multiple-indicator approach, targeting various inflation metrics like CPI, WPI, core WPI, core CPI, inflation expectations, growth, and fiscal and current account balances, among other variables, sometimes according to its own convenience. This has made monetary policy unpredictable for market participants at times and has also hurt the RBI's credibility as its goal or “the nominal anchor” is unclear.


According to Nomura, the key focus of the Urjit Patel Committee recommendations will be to make the monetary policy framework and/or operative procedure much more transparent and predictable


Price stability instead of a multiple-indicator approach:

We expect the committee to recommend a move towards price stability, i.e. low and stable inflation as the sole policy objective instead of the current multiple indicator approach. Although the multiple indicator approach has worked well so far, the RBI has only one instrument (interest rates) to achieve multiple goals, which may be distracting it from achieving its central objective of price stability.


The move from a multiple-pillar approach to inflation targeting has to be gradual. The main features of inflation targeting are its medium-term focus, the use of an inflation forecast and the explicit public announcement of an inflation target or sequence of targets.


CPI inflation as the new nominal anchor:

The committee will recommend a new nominal anchor for monetary policy. A nominal anchor is a variable that monetary policy can use to direct the expectations of economic agents regarding price levels in the economy and what policy makers may do to achieve them.


India currently has no nominal anchor and there is substantial confusion as to whether the RBI is targeting the WPI, the CPI, a combination of the two or their core measures. In our view, the RBI will move away from WPI inflation as its primary inflation target because it largely reflects tradable goods price inflation, which is more relevant for producers and does not capture inflation in non-tradables (services), which is more relevant for consumers. We believe the debate is more likely to focus on the benefits of adopting headline CPI versus core CPI inflation as the new nominal anchor.


Headline CPI inflation is driven largely by food price inflation and hence is susceptible to supply shocks. The advantage of targeting core CPI inflation is that it excludes the volatile food and fuel categories and includes a basket of services or non-tradable goods. But ignoring headline CPI inflation has its own pitfalls. Food price inflation plays a crucial role in driving inflation expectations in India, which drives wage-setting behaviour and in turn affects core CPI inflation. Headline CPI inflation is also easier to communicate and to understand even for an average household. Therefore, we think it more likely (65% probability) that the RBI adopts headline CPI inflation as the new nominal anchor, and assign a 35% probability to it adopting core CPI inflation as the new anchor.


Numerical inflation targets:

Having adopted an inflation target, we would expect the committee to recommend a numerical inflation target or a sequence of targets that the RBI should announce on CPI inflation and to which it will be held accountable. We believe that the committee may recommend target ranges to which CPI inflation needs to be reduced over time. This may involve requiring that CPI inflation be brought down to 8-8.5% in the next year (11% currently), to 7-8% over the next two years and so on. A staggered and gradually falling inflation target would make it appear more credible.


Continue with the existing liquidity framework:

We expect the RBI to broadly stick to its current framework of: 1) keeping liquidity in deficit for better policy transmission; 2) the repo rate being the sole policy rate and 3) the weighted average overnight call money rate being the operating target of monetary policy. Hence, one instrument (repo) and one target (CPI) appears to be a more likely outcome. Tight liquidity with a greater reliance on the term repo facility to meet the liquidity mismatches would help develop the term money market and encourage banks to rely more on their own deposits for lending.


Impediments to policy transmission: The committee has also been asked to look into the less-than-desirable transmission channel of policy repo rates to bank lending and deposit rates (Figure 4). Historically, liquidity has been an important driver of transmission as it drives banks? cost of funds. Hence, tight liquidity during a hiking cycle (or easy liquidity during an easing cycle) is necessary to accelerate transmission from policy to bank lending/deposit rates.


However, government finances have wreaked havoc with the RBI’s liquidity calculations in the past through either a sudden burst in spending (higher liquidity) or sudden fiscal austerity (liquidity tightening). One way to resolve this is to auction the government's surplus cash balances, which are currently held as deposits with the RBI (Mohanty, 2011). Additionally, government interference in public sector banks’ interest rate decisions needs to be curtailed. Further, increasing the penetration of the banking system is essential to increasing and speeding up the transmission of monetary policy to the real economy.


Setting up a monetary policy committee:

Currently, the RBI has set up a technical advisory committee, which advises it on the desirable stance of monetary policy. However, the final rate decision rests solely with the RBI governor. We believe that the committee could recommend setting up a monetary policy committee with voting members to decide on policy rates with members possibly drawn from the RBI, Ministry of Finance, academia and the corporate sector.


Greater transparency and communication policies:

As recommended by the Committee on Financial Sector Reforms (2009), the RBI could develop and make public its inflation model to give some guidance to market participants on monetary policy decisions. As price stability becomes the RBI's primary mandate, it could produce its own version of the inflation report, which provides detailed economic analysis and inflation projections, on the basis of which interest rate decisions are made. Detailed minutes of the RBI's monetary policy committee may also be publicly released.


According to Nomura, The move from one regime to another cannot be sudden. First, CPI inflation is driven not just by demand, but also by fiscal policy, indexation and other supply-side factors. Hence, if the RBI moves towards a CPI inflation-targeting regime, government policies need to be prudent, otherwise the RBI may end up setting targets that are too ambitious, thereby hurting its own credibility. A central bank can always lower inflation – it has the tools to affect relative prices – but at the sacrifice of growth.


Second, moving to a CPI regime suggests that interest rates will remain higher for longer. We expect CPI inflation to remain elevated at above 9% y-o-y over the next year as well, which will necessitate further policy action. We are currently pencilling in a cumulative 50bp repo rate hike to 8.25% in 2014 and our bias is to the upside. 


Third, although there would be some growth sacrifice in the near term, a successful inflation-targeting framework should have positive medium-term benefits for India, Nomura added.


The report of Urjit Patel Committee is due around the end of December.


Inflation Index Bonds – How will the taxation impact you?

Inflation Indexed Bonds are a welcome option for a long-term conservative saver. Find out how the taxation works before you plunge into the product. The returns will vary based on your tax bracket. It will work well as a retirement savings tool for those in the lower tax bracket

Inflation Indexed National Savings Securities-Cumulative (IINSS-C) securities are being launched by the Reserve Bank of India (RBI) in the backdrop of announcement made in the Union Budget 2013-14 to introduce instruments that will protect savings from inflation. Interest rate on these securities would be linked to final combined Consumer Price Index [CPI (Base: 2010=100)]. Interest rate would comprise two parts - fixed rate (1.5%) and inflation rate based on CPI and the same will be compounded in the principal on half-yearly basis and paid only at the time of maturity. E.g. CPI of 11.24% in November 2013 means you can expect to get 12.74% pa assuming inflation stays at the same level. The minimum and maximum investment per annum is Rs5,000 and Rs5 lakh respectively. The tenor is fixed at 10 years.


Do not misinterpret the taxation of IINSS-C; there are conflicting media reports on tax issue. Some media reports talk about considering payment as capital gains, which will lower the tax rate. But, ignore such misinterpretation and calculate tax payments based on your tax slab. According to Vivek Sharma, a personal-finance expert, “There is no special tax treatment of inflation indexed bonds. These will be treated as normal bonds and taxed.”

Tax treatment on interest and principal repayment would be as per the extant taxation provision. Tax will be levied on the interest as per your tax bracket, which is inline with bank FD taxation. INSS-C is suitable for those in lower tax bracket (up to 10%). It is a better option than bank fixed-deposits (FD). IINSS-C may work out well for those in 20% tax bracket if inflation remains at current level for much of the 10 year tenor. Those in highest tax bracket will do better with tax-free bonds.

Read - Inflation Index Bonds & Bank FD – Early redemption penalty decoded

One drawback with cumulative FDs is that you have to pay tax on the interest that you don’t receive in hand. You get the interest only on maturity of the cumulative FD, but tax on the accrued interest is payable for each financial year in which it accrues. The same will be an issue with IINSS-C. The government will earn the tax payment on accrued interest without paying you any interest for 10 years. The higher the inflation, the higher the accrued interest and hence more tax will be collected. If the inflation dips, the government will benefit by having to pay lower interest on product maturity. RBI circular specifies that issuance of non-cumulative inflation indexed bonds for retail investors will be examined in due course. It will have to be seen if and when non-cumulative option really comes.

According to Vivek Rege, SEBI registered investment adviser, “IINSS-C will give variable income, which is cumulative. It means income is earned and re-invested as per the product feature and conditions, once income is accrued it is taxable in the hand of the individual as per tax bracket. Income tax offers flexibility of cash or accrual basis, but cash basis will not work practically since all interest will be taxed in one single year and hence it will be offered for tax each year. Income tax does offer both options to the assessee in case of accrual products, but it should be uniform and not instrument wise.”

According to Rajesh Gada, chartered accountant, “If an assessee is following mercantile system, then he/she will pay tax on accrual interest either by way of advance tax or self-assessment tax while filing return. If assessee is following cash system in respect of interest income, then entire income to be shown at the time of final receipt and tax to be paid when money received. For ‘income from other sources’, normally one pays tax on the basis of mercantile system even though they are not receiving actual payment. From accounting principle point of view and direct/indirect taxation point of view, mercantile system is better for majority of cases. If Form 26AS shows TDS and correspondingly assessee is not showing income, IT officer can question why income is not shown and assessee need to face issues to explain and prove accounting system. Similarly, if one is declaring income at the time of receipt of interest (at maturity) at the end of 10 year, there will be practical difficulties to claim tax credit (i.e. credit of TDS of all the previous year to be clubbed in the year of receipt of income). At present, income tax return does not have provision to give reconciliation, so practically, mercantile system is better.”


Devyani Khobragade, India’s deputy consul general released on bail

Khobragade, a mid-level Indian diplomat, was released by a Manhattan court on a $250,000 bond

Devyani Khobragade, deputy consul general at the Indian Consulate in New York was arrested for allegedly presenting fraudulent documents in support of a visa application for an Indian national employed by her. Khobragade, a mid-level Indian diplomat, was released by a Manhattan court on a $250,000 bond on Thursday evening even as the Indian embassy in Washington expressed 'strong concern' over the unprecedented action by the US.


Manhattan’s top federal prosecutor Preet Bharara said, Khobragade, an officer from the Indian Foreign Services (IFS) was held on charges that she allegedly caused a materially false and fraudulent document to be presented, and materially false and fraudulent statements to be made, to the US Department of State in support of a visa application for an the Indian national employed as a babysitter and housekeeper at her home in New York.


Indian officials, however, said the housekeeper, Sangeeta Richard, has been absconding since June 2013, and in September, the Delhi High Court had issued an-interim injunction Richards from instituting any actions or proceedings against Khobragade outside India on the terms or conditions of her employment.''


Khobragade is currently employed as the deputy consul general for Political, Economic, Commercial and Women’s Affairs at the Consulate General of India in New York. She is daughter of former IAS officer Uttam Khobragade and also member of the controversial Adarsh Housing Society in Mumbai.


“The false statements and fraud alleged to have occurred here were designed to circumvent those protections so that a visa would issue for a domestic worker who was promised far less than a fair wage. This type of fraud on the United States and exploitation of an individual will not be tolerated,” he said.


Khobragade was charged with one count of visa fraud and one count of making false statements, which carry maximum sentences of ten years and five years in prison, respectively.


“Foreign nationals brought to the US to serve as domestic workers are entitled to the same protections against exploitation as those afforded to US citizens,” Bharara said.


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