The Monetary Policy Committee

In one line

Since 2016 the interest rate is not the Governor's decision: it is decided by a six-member statutory committee, by majority, on a published vote, against a target the Government sets.

In the wording a student can write in an exam: Chapter IIIF of the Reserve Bank of India Act, 1934, inserted by the Finance Act, 2016, provides that the Central Government shall in consultation with the Bank determine the inflation target in terms of the Consumer Price Index once in every five years and notify it; that a Monetary Policy Committee of six members shall be constituted, three from the Bank and three appointed by the Central Government; that the Committee shall determine the policy rate required to achieve the inflation target; that its decisions are binding on the Bank; and that where the Bank fails to meet the target it shall report to the Central Government the reasons for the failure, the remedial actions proposed and the time within which the target will be achieved.

Why the Committee was created

Before 2016 the interest rate was the Governor's decision. He took advice from a technical advisory committee whose views were not binding and whose votes were not published, and he announced a rate. There was no statutory objective, no target, and no record of who thought what.

Three defects followed, and each is a reason for the reform.

No accountability against a standard. With no target, the Bank could not be said to have succeeded or failed. Criticism was about judgment, which is unanswerable in either direction.

No protection from pressure. A single decision-maker appointed by the Government, removable by it under section 11 as chapter 220 records, is exposed. A committee with outside members and a published vote is much harder to lean on.

No transparency. Markets and borrowers had to infer the Bank's reaction function from its statements. A published target, a published vote and published minutes make policy predictable, which is itself valuable, because expectations are half of how monetary policy works.

The reform came in two steps. The Monetary Policy Framework Agreement between the Government and the Bank in 2015 set an inflation target by agreement, and the Finance Act, 2016 then inserted Chapter IIIF, putting the framework in the statute.

The target: section 45ZA

Section 45ZA(1). "The Central Government shall, in consultation with the Bank, determine the inflation target in terms of the Consumer Price Index, once in every five years."

Section 45ZA(2). The Central Government shall, upon such determination, notify the inflation target in the Official Gazette.

Three things in that section are worth noticing, and each is examinable.

The Government sets the target, not the Bank. That is the correct constitutional allocation: what inflation rate a country should aim for is a political judgment about the trade-off between inflation and growth, and an elected Government should make it. What is required to achieve it is a technical question, and that is the Bank's.