Why does India have a Monetary Policy Committee?

We almost did not have one!

If you want to reach somewhere, you have to first decide the direction.

Similarly, a country looking to prosper has to make certain goals, milestones. And they need to have a qualified bunch of people who can responsibly set these goals and make the right decisions to achieve them. 

Currently, India has a Monetary Policy Committee that takes decisions to keep inflation under check, so that there are no hiccups in our country’s path to glory. Easy, no?

Well, solutions that often look so easy today usually have a troublesome history. You see, before the year 2016, there was no Monetary Policy Committee at all!

So let’s start from the very beginning.

Remember 1991? It was the landmark year when India’s economy was opened to global trade. Restrictions were brought down. Doing business in India was made easier. 

But, that added another layer of complexity. Gradually, the number of variables that were important to determine the state of the Indian economy went up. If the RBI and the government were to keep things under check, they needed to keep an eye on ‘multiple indicators’ such as inflation, growth, employment, exchange rate, and banking stability before making any decision. 

RBI was constantly scrutinized and criticized by someone or the other. Why?

Because it was trying to cater to the needs of both the government and the general public at the same time. You know how juggling between various responsibilities can be difficult, right? No one’s happy at the end of the day. Nevertheless, it continued doing its job. 

The global financial crisis of 2008-09 came as the final blow. Drastic measures had to be taken to bring the economy back on the growth path. And so, this multi-indicator approach was questioned in the wake of growing inflation and weakening growth.

RBI set up an expert committee in 2013 under Dr. Urijit Patel (then Deputy Governor, RBI) to review the existing framework and suggest changes. And well, they realized that instead of trying to be a jack of all trades, RBI could focus on the most important economic indicator and be the master of one. So, the committee came to a consensus that “inflation targeting” should be the main objective of the monetary policy. By adopting this, RBI now follows a system aligned with most global central banks including the US Federal Reserve. We have Dr. Raghuram Rajan to thank for leading this and making it happen.

Now, before we go any further, let’s first understand what inflation targeting really means.

Inflation is the rate (%age) at which the value of some goods and services that we usually consume goes up. What inflation targeting does is that it sets a range for acceptable inflation, instead of keeping a concrete number as the goal.

Now, it takes two to tango. While RBI focuses on inflation (mehangai), the government focuses on GDP (kamaayi). 

But, why inflation? Why not any other indicator?

Because inflation reflects stability in the economy. You see, inflation is directly linked to the prices of all goods and commodities. Here’s what will happen if there is a major upward swing in the price:

Your cost of living, cost of borrowing, and any other cost that you can think of will rise. 

You can now buy fewer things with the money that you have (your purchasing power erodes). 

You will probably think of cutting down on your expenses and you will start consuming less. 

And so, there will be less economic activity in the country. GDP will nose dive, which is not good for any economy. 

But, what if prices fall miserably? You must be thinking, prices are falling, acchi baat hui na? 

Well, no. Think about it. If prices are falling continuously, why would any company want to produce more and sell more for a lesser price? Their margins would go down. 

Instead, they will delay production. Since they are not producing and therefore not selling at their usual rate, it means lower sales and thus lesser profits. 

They will then want to cut down their expenses. Salaries will go down, unemployment will increase. 

Now, what will people like you and me do? If prices are falling continuously, we will assume that they’ll fall even further and thus, delay purchases. This will reduce the overall demand in the economy. Now, since both demand and supply are lesser than usual, prices might keep falling and the economy will be stuck in a vicious cycle.

You see how a stable inflation rate holds a very vital key for a stable economy?

MPC has some cool tricks up its sleeves that can help in keeping inflation under check!

Wait, what are these? 

Hahaa. Patience. Absorb this for today, and stay tuned. Talk to you tomorrow! 

Until then, take care, stay safe, and ReadOn!

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