The finance ministry and RBI will put in place a new framework for setting interest rates by the year-end, which will give powers to the government and Parliament to fix the inflation target. Based on the target, a monetary policy committee will then decide the interest rates, effectively taking away RBI’s exclusive control over monetary policy.
“What is the appropriate inflation target for India cannot be decided by the RBI, it has to be decided by the government. The government may decide in consultation with Parliament, government may decide on its own,” said a source. Several contentious issues are yet to be thrashed out, such as the membership of the monetary policy committee.
For long, the RBI and the government have been engaged in a battle on how interest rates should respond to inflation. During UPA’s term in office, the finance ministry repeatedly prodded the RBI to cut interest rates, arguing that it will help boost growth, but the central bank refused to oblige, creating unprecedented tension. So far, the BJP government has shied away from nudging the RBI to cut rates amid signs that price rise is slowing down.
In several countries, a similar structure is already in place, where a monetary policy panel fixes rates. The move to change the structure comes amid debate over RBI’s powers in the future and the primacy it enjoys among financial sector regulators.
The Financial Sector Legislative Reforms Commission (FSLRC), set up by UPA has recommended sweeping changes, in the regulatory architecture including a smaller role for the RBI, something that governor Raghuram Rajan has publicly opposed. He has, however, backed the plan for a monetary policy committee (MPC), with an inflation target of 4%, with a scope for a 2% movement on either side. A committee headed by RBI deputy governor Urjit Patel, which had recommended MPC, had also suggested that the target should be to lower retail inflation to 8% by January 2015 and 6% by January 2016.
While work on implementing the FSLRC recommendations is under way, official sources said internal work for the new monetary policy framework is in advanced stages and the government will have to take a final view on it in consultation with RBI by December-end. In his maiden Budget, finance minister Arun Jaitely had also talked about putting in place a modern framework.