Journal of Financial Regulation, 2016, 2, 283290

doi: 10.1093/jfr/fjw010
Advance Access Publication Date: 9 June 2016
Panorama

Current Developments in Indias Monetary

Policy Framework
Vishrut Kansal*
ABSTRACT
The article traces, and presents a brief analysis of, the recent landmark developments in
Indias monetary policy framework, including the shift of primary focus to price stability
(through exible ination targeting) and the creation of a Monetary Policy Committee

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with independent experts to set the binding policy rate upon the Reserve Bank of India.

I. MONETARY POLICY FRAMEWORK AND CENTRAL BANK

IN DE PEN D EN CE IN I NDI A
The monetary authority of a country (the central bank or a regulatory committee) is
usually responsible for conducting monetary policy through an institutionalized macro-
economic policy framework consisting of the use of instruments under its control to
regulate the supply, cost, and use of money and credit. The supply-side macroeco-
nomic policy, on the other hand, is the fiscal policy set by the fiscal authority of the
country (usually, the government) to stimulate growth in gross domestic product
(GDP), cut unemployment, control inflation, and stabilize business cycles by adjusting
tax rates, subsidies, borrowings, spending priorities, etc. Absolute independence of
monetary and fiscal authorities, with a lack of any mutual coordination or interaction,
may lead to the formulation of conflicting policies. Similarly, rendering monetary
policy goal-dependent on a dominant fiscal policy is also undesirable because: (i)
time-inconsistency problems may arise (monetary policy is usually medium- to long
term while fiscal policy is short term); and, (ii) electoral expectations and political
pressures that may influence fiscal policy must not influence the monetary policy.
Therefore, information exchange and mutual coordination must exist between the two
authorities to ensure that both policies act as strategic complements. In developing
countries like India where monetary policymaking takes place in the shadow of fiscal
dominance and the monetary authority is accountable to the fiscal authority, the inter-
action between the monetary and fiscal policy is conditioned by the degree to which
the monetary authority enjoys institutional independence from the fiscal authority.1

* Vishrut Kansal is currently pursuing B.A.LL.B.(H) from the WB National University of Juridical Sciences
(NUJS), Kolkata, India. Email: vishrutkansal@nujs.edu
1 Janak Raj, JK Khundrakpam and Dipika Das, An Empirical Analysis of Monetary and Fiscal Policy
Interaction in India (2011) RBI Working Paper Series No 15 <https://www.rbi.org.in/Scripts/
PublicationsView.aspx?id=13841> accessed 5 April 2016.

C The Author 2016. Published by Oxford University Press. All rights reserved.
V
For Permissions, please email: journals.permissions@oup.com

 283
284  Journal of Financial Regulation

In India, section 3 of the Reserve Bank of India (RBI) Act 1934 (Act) constitutes
RBI for carrying on the business of banking in accordance with the Act and section
45W empowers RBI to calibrate Indias monetary policy. Therefore, RBI is the mone-
tary authority of India with its central board consisting of nominees and appointees of
the Government of India (GoI) (the fiscal authority). With predominant control exer-
cised statutorily by the GoI on its institutional and financial aspects, the RBI lacks legal
and institutional independence, with hardly any trappings of financial independence.
Additionally, Preamble to the Act expressly states that its goal is to secure monetary sta-
bility, thereby limiting its goal-independence. Left only with the independence to de-
cide upon the policy instrument(s), RBI enjoys instrumental and operational
autonomy, and is also limited in practice by its conventional resort to repo rate.
Bereft of any independence that could be exercised as a right rather than as a priv-
ilege, many contradictions have arisen in the past with respect to the RBIs function

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to conduct Indias monetary policy in shadow of the GoIs fiscal dominance.
However, efforts were consistently made to reduce such contradictionsyields on
government bonds were market-determined post 1985; automatic monetization of
fiscal deficit through creation of ad hoc treasury bills was completely phased out post
1998; and section 5 of the Fiscal Responsibility and Budget Management Act 2003
prohibited RBI to buy government securities directly from the primary market.
Despite these efforts, GoIs continued fiscal indiscipline (in incurring large fiscal
deficit) and lack of policy coordination continued to affect the RBIs ability to
conduct monetary policy. A need to reform Indias monetary policymaking was long
overduethe only issue was whether this should be done through changes in the
current institutional framework or a major legislative overhaul.

I I . T EC H N I C A L A D V I S O R Y C O M M I T TE E : NE E D F O R RE F O R M
Even though section 45W of the Act empowers the bank ie the RBI to determine the
monetary policy, this power is technically exercised by the RBI Governor vide section
7(3). The Governor, despite being of sterling caliber, may fault in his judgment in singly
taking monetary policy decisions. Conventionally therefore, a Technical Advisory
Committee on Monetary Policy (TAC) under the chairmanship of the RBI Governor
has been regularly constituted by the RBI (since July 2005) as an internal committee to
make monetary policy formulation more consultative, with advice being sought from ex-
ternal experts serving as members of the committee. Since February 2011, in the interest
of transparency, the RBI has consistently disclosed in the public domain TACs minutes
of meetings (that usually take place once per quarter) with a lag of roughly four weeks.
However proactive, any views expressed by the TAC shall always remain merely
advisory and non-binding upon the RBI Governor, who is statutorily vested with un-
bridled powers to set the policy rates. To a limited extent however, the current regu-
latory scheme imposes an ex post accountability on the RBI (and not the TAC)
against any failure in achieving its monetary policy objectives: (i) section 11(1) of
the Act empowers the GoI to remove the RBI Governor who has consistently failed
to achieve monetary stability; and (ii) section 30 allows the GoI to supersede the
RBIs central board if it fails to carry out its obligations under the Act, including suc-
cessful conduct of monetary policy. This ex post accountability framework is
 Developments in Indias Monetary Policy Framework  285

understandably inadequate in detecting flawed monetary policies, especially when

the markets themselves are confused by sporadic intervention of the RBI pursuant to
its mixed-targets approach (MTA) (see below).

II I . G O A L- S ET T IN G A ND N O M I NA L A N CH O R : NE E D F O R R E FO R M
The goal of the RBIs monetary policy, as stated in the Preamble to the Act, is to se-
cure monetary stability. Monetary stability means sustaining confidence in the cur-
rency by stabilizing its value, measured usually in terms of its domestic purchasing
power (price level). Therefore, monetary stability is used synonymously with price
stability, which is in turn defined in terms of low and stable inflation and not by sta-
tionary price levels. Therefore, the Act indicates that the role of the RBI is to stabilize
inflation expectations; but it leaves issues like the appropriate nominal anchor, the
monetary policy approach, its operating framework, etc unaddressed.

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Institutionalization of a nominal anchor ensures synchronization of monetary pol-
icy objectives with the expectations of other rational economic agents so that the
time-inconsistency problem is resolved. The resultant rule-based monetary policy
framework lends predictability, credibility, transparency, and certainty. An absolute
lack of a nominal anchor, on the other hand, leads to formulation of a monetary pol-
icy on a period-to-period basis, strongly dependent on individual skills (or institu-
tional excellence) and political independence of the monetary authority.
In India, where the RBI Governor enjoys exclusive power to conduct monetary pol-
icy (see above), the absence of any nominal anchor would render the nations monetary
policy vulnerable to sharp divergences with critical policy changes based on the change
in leadership. Therefore, in a quest to secure an optimal nominal anchor best suited to
Indias socio-politico-economic scenario, the RBI has experimented with gold standard
(till 1957), credit aggregates (195785), monetary targeting (198598) and the MTA
(a.k.a. the multiple indicator approach). Adopted in its Annual Monetary Policy
Statement of April 1998, the MTA lent monetary policy perspective through an analysis
of multiple forward-looking indicators viz. quantity variables (like capital flows) and rate
variables (like inflation rate, exchange rate). Post 20082009 however, there was a con-
sistent downtrend in the GDP coupled with mounting inflation (both wholesale and re-
tail) that led to severe criticism of the MTA for its opacity and failure to provide a
definite nominal anchor.2 The MTA, being uncertain of whether the RBI is focusing on
maintaining the exchange rate (through capital flows) or the inflation rate, confused the
market, thereby hurting investment, credit, and growth opportunities.
The High Level Committee on Financial Sector Reforms, constituted by the
Planning Commission of India under the chairmanship of Raghuram G. Rajan
(Rajan Committee), in its report titled A Hundred Small Steps (2009), renounced
the MTA in favour of a formally announced inflation target as the single objective,
and short-term interest rate (repo and reverse repo) as the single instrument for
RBIs monetary policy framework (following the Tinbergen assignment rule of single
policy single instrument). The RBIs sole focus on maintaining low and stable infla-
tion in the medium term and intervention only to the extent of limiting excessive

2 Urjit Patel, Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (2014)
<https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/ECOMRF210114_F.pdf> accessed 5 April 2016.
286  Journal of Financial Regulation

volatility in currency markets, according to the Rajan Committee, would stabilize the
exchange rate, thereby encouraging exports, foreign investment in rupee denomi-
nated corporate and government bond market, and domestic long-term investments,
all eventually leading to higher growth in the long term.

I V. P R O P O SE D I ND I A N F IN A NC I A L CO D E 2 0 1 3
Financial Sector Legislative Reforms Commission (FSLRC), under the chairmanship
of B.N. Srikrishna, in its March 2013 report proposed an Indian Financial Code
(IFC 1.0). Therein it proposed price stability as a desirable goal and left it upon the
GoI to declare predominant and additional/secondary objectives for the RBIs mone-
tary policy. The objectives, along with their quantified medium-term targets, were to
be provided by the GoI, in a statement issued every two years, in consultation with
the RBI Governor. It, therefore, proposed to completely take away the goal-

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independence of the RBI and to render the monetary policy goal-dependent on the
fiscal policyan undesirable outcome (see above).
On the operational front, while the IFC 1.0 proposed to retain the RBIs responsi-
bility to formulate and implement monetary policy, the actual responsibility of for-
mulating monetary policy was to be conferred on a Monetary Policy Committee
(MPC) whose decisions were to be binding on the RBI. This would have created an
inconsistencynowhere was it proposed to constitute MPC as the RBIs internal
committee. In fact, MPC was proposed to be a seven-member committee, under the
chairmanship of the RBI Governor, consisting of only one executive member to be
appointed by the RBI Board and the rest to be independent experts, of which three
were to be appointed solely by the GoI and two in consultation with the RBI
Governor. Then, holding the RBI responsible for MPCs failure to formulate a mone-
tary policy that could not achieve the GoI-declared target would have been unreason-
able. The sole indication of the RBIs increased control over MPC was the right
proposed to be given to the RBI Governor to supersede MPCs decision(s) in ex-
ceptional and unusual circumstances, a phrase that was left undefined.
As per section 7(1) of the Act, GoI may issue to the RBI any directions it deems
fit in public interest, which are binding on the RBI. Since GoI could keep such direc-
tions confidential and avoid public censure and accountability, IFC 1.0 proposed
omission of section 7(1) of the Act in the interest of transparency and public ac-
countability. Controversially, however, IFC 1.0 empowered the GoI to issue to the
RBI recommendations in writing, which if rejected by the MPC, would have allowed
the GoI to take direct control over RBI with respect to monetary policy.
To consider carefully the recommendations of FSLRC, the RBI constituted an
Expert Committee to Revise and Strengthen the Monetary Policy Framework under
the chairmanship of Dr. Urjit R. Patel (Patel Committee), which was to advise
on an appropriate nominal anchor and on MPC for conduct of Indias monetary
policy.

V . P A T EL C O M M IT T EE R EC O M M EN D A T I O N S
After duly considering the recommendations of the Rajan Committee and the
FSLRC-proposed IFC 1.0, Patel Committee recommended adoption of Flexible
 Developments in Indias Monetary Policy Framework  287

Inflation Targeting (FIT), with inflation measured in terms of CPI-C as the nominal
anchor. FIT meant maintaining low and stable inflation around predetermined target
rate in the short term while stabilizing real economy, maintaining price stability, and
stimulating sustainable growth in the medium term. Accordingly, inflation was to be
maintained at 4 per cent with a band of (/) 2 per cent as the predominant objec-
tive of the RBIs monetary policy, and disinflation from a current level of 10 per cent
to a recommended target of 4 per cent through a glide path spanning across three
years. It also recommended making fiscal policy a strategic complement to the mone-
tary policy in achieving price stability, through bringing down fiscal deficit,
de-administering prices, wages, and interest rates, and maintaining transparency, co-
ordination, and clear communication.
On the operational front, the Patel Committee recommended constituting a five-
member MPC under the chairmanship of the RBI Governor and, consisting solely of

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the RBI directors and their nominees (without any direct government nomination or
representation). Each member could exercise one vote, with Chairman being given a
second and casting vote for tie-resolution. The MPC (and not the RBI) was to be
held accountable for failure to achieve the inflation target.
Notably, an MPC stuffed with internal members of the Central Bank is usually
prone to group-think and power imbalancecolleagues of the Central Bank
Governor are more likely to be inclined to share the same view as the Governor him-
self.3 Involving external independent experts from different backgrounds in the MPC
thus assumes significance in ensuring individuality in the consolation process and
bringing different viewpoints and decision heuristics to the table.4

V I . M O N E T A R Y PO L I C Y F R A M E W O R K A G R EE M E N T
By April 2014, the RBI implemented FIT (as recommended by the Patel Committee)
through adoption of CPI-C as the key measure of inflation, and of the glide path of
disinflation to 6 per cent CPI-C measured inflation by Jan 2016.5 Thereafter, on 20th
February 2015, the RBI entered into a Monetary Policy Framework Agreement
(MPFA) with the GoI, which explicitly recognized the primary objective of monetary
policy as maintaining price stability, while keeping in mind the objective of growth.
This predominant objective of price stability was to be achieved through FIT (as had
already been implemented by the RBI). Accordingly, the RBI was required to target

3 For instance, Alan Greenspan wielded wide influence over US Federal Open Market Committee and main-
tained prolonged period of low interest rates that encouraged bubble in housing prices, ultimately culmi-
nating in 2008 sub-prime mortgage crises, See Katalina M Bianco, The Subprime Lending Crisis: Causes and
Effects of the Mortgage Meltdown (CCH 2008) <https://business.cch.com/images/banner/subprime.pdf>
accessed 5 April 2016.
4 Philipp Maier, Monetary Policy Committees in Action: Is There Room for Improvement? (2007) Bank
of Canada, Staff Working Paper 2007-6 <www.bankofcanada.ca/wp-content/uploads/2010/02/wp07-6.
pdf> accessed 5 April 2016.
5 RBI, First Bi-monthly Monetary Policy Statement, 2014-15 By Dr. Raghuram G. Rajan, Governor (Press
Release, 1 April 2014) <https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=30911>
accessed 5 April 2016; RBI, Third Quarter Review of Monetary Policy 2013-14: Statement by Dr.
Raghuram G. Rajan, Governor, Reserve Bank of India (Press Release, 28 January 2014) <https://www.rbi.
org.in/scripts/BS_PressReleaseDisplay.aspx?prid=30495> accessed 5 April 2016.
288  Journal of Financial Regulation

inflation, as measured by monthly CPI-C in percentage terms, below 6 per cent by Jan
2016 and, 4 per cent (/) 2 per cent for 201617 and onwards.
Clause 3 of the MPFA, in consonance with the Act, states that the RBI Governor
shall determine the policy rate to achieve the inflation target; and Clause 6 states the
consequences of the RBIs failure to do so. If the RBI fails to meet the inflation tar-
get, it is required to submit a report to the GoI detailing the reasons for its failure, re-
medial actions proposed to be taken, and an estimate of the time period within
which the target would be achieved thereafter. However, there is no scope for the
RBI to dispute its responsibility or assert in its report that the external pressures, sup-
ply shocks or fiscal indiscipline, over which RBI has no control, caused its failure to
achieve the target. MPFA may, therefore, provide a leeway to the GoI to continue
raising fiscal deficit (in disregard of the Patel Committee recommendations) and at-
tribute responsibility on the RBI for rising inflation. Ideally, MPFA must be supple-

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mented by a proper fiscal policy framework.
MPFA now makes it unequivocal that price stability is the predominant objective
of Indias monetary policy with medium-term focus on real economic growth. Also,
adopting CPI-C as the nominal anchor arguably led to a transition from erstwhile
opaque MTA to an institutionalized rule-based inflation-targeting monetary policy
framework. Contrarily, one may argue that insofar as the inflation targets are men-
tioned only in the MPFAwhich is, after all, just an agreement between the ruling
government and the RBIit does not concretely institutionalize a rule-based frame-
work. A lasting solution would have been to legislatively incorporate within the Act
such a framework providing for medium- to long-term inflation targets (see below).

VII. DRAFT INDIAN FINANCIAL CODE BILL 2015

On 23 July 2015, the Finance Ministry of India published an amended version of
IFC 1.0, the Indian Financial Code Bill 2015 (IFC 1.1). Much like MPFA, IFC 1.1
stated the objective of monetary policy to be price stability while striking a balance
with the objective of the Central Government to achieve growth. The addition of
the words Central Government was to propose making monetary policy goal-
dependent on fiscal policy. To this end, IFC 1.1 stated that the inflation target shall
be determined by the GoI in consultation with the RBI every three years. Therefore,
prima facie, the GoI could, in disregard of the RBIs recommendations, fix an infla-
tion target. Reaching an agreement with the RBI on an inflation target or publicly
disclosing the reasons for adopting such a target (having regard to consultation with
the RBI or in disregard thereof) would have been discretionary upon the GoI.
On the operational front, IFC 1.1 proposed constitution of a seven-member MPC
under the chairmanship of the RBI Governor and consisting of one member of the
RBI Board (nominated by the RBI Board), one RBI employee (nominated by the
RBI Chairperson), and four external experts to be appointed by the GoI. Each mem-
ber could exercise only one vote, without any exception. The formulation and imple-
mentation of the monetary policy was stated to be the function of the RBI and the
RBI was correspondingly made responsible for failure to meet the inflation target. In
effect, therefore, like IFC 1.0, IFC 1.1 also proposed MPC to be the actual monetary
authority without any accountability, and the RBI to be reduced to merely a nominal
 Developments in Indias Monetary Policy Framework  289

monetary authority bound by the decisions of the MPC, of which it would ostensibly
be the constitutor, and by that fact, accountable for its failure.
Four external members, who were to be appointed by the GoI to the MPC, were
to be selected from a pool of candidates shortlisted by the Selection Committee.
The Selection Committee, under the chairmanship of a GoI nominee, was to consist
of three independent experts and, a variable member. For appointment of members
of a Financial Agency (including the RBI), the variable member was to be the
Chairperson of the Financial Agency. Accordingly, the RBI Governor would have
been the variable member of the Selection Committee to propose candidates to the
GoI for their appointment to MPC. Four members, selected by the GoI out of a
pool of candidates proposed by the Selection Committee that includes the RBI
Chairperson as its member, would not have been stricto sensu external to RBI.
Furthermore, there was no provision in the IFC 1.1 to ensure that the members cho-

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sen by the Selection Committee for appointment to MPC or those ultimately ap-
pointed by the GoI to the MPC were experts in monetary policy matters and
politically independent. Ensuring that the Selection Committee is comprised of inde-
pendent experts does not, in turn, ensure that the members chosen by the Selection
Committee will also be independent and experts in given fields.

V I I I . FI N A N C E B I L L 2 0 1 6
On 29 February 2016, GoI introduced Finance Bill 2016 in the House of the People
(Lok Sabha) of the Parliament of India that will amend the Act to institutionalize
MPFA and constitute an MPC.6 The Preamble to the Act will be accordingly
amended to state the primary objective of monetary policy as maintaining price sta-
bility while keeping in mind the objective of growth. Like IFC 1.1 (see above), it
states that the inflation target in terms of CPI-C will be decided by the GoI in consul-
tation with the RBI (once in every five years) and thereafter notified in the official ga-
zette. Despite the continued institutional dominance of fiscal authority, this is
expected to at least make a transition from erstwhile fiscal dominance to mutual
cooperation in monetary policy making.
On the operational front, a six-member MPC will be constituted under the chair-
manship of the RBI Governor, with the Deputy Governor in charge of monetary pol-
icy and a bank officer nominated by the central board to be the ex officio members.
Three other members will be independent experts appointed by the GoI on recom-
mendations made by the search-cum-selection committee consisting of the RBI
Governor as its member. They will be appointed for four years and will be ineligible
for reappointment. Their terms and conditions of appointment, including remunera-
tion and other allowances payable will be as per the regulations made by the RBI.
Insofar as rendering monetary policy subservient to fiscal dominance is advised
against (see above); the Finance Bill 2016 ensures that the appointment of external
members to MPC by the GoI is made at arms length (to allay fears of politicization

6 A Finance Bill is a Money Bill (under article 110 of the Constitution of India) that is introduced every
year in the Lok Sabha after the presentation of the Union Budget, to give effect to the financial proposals
of the Government of India for the immediately following financial year. Given the clear majority of the
National Democratic Alliance led by the Honble Prime Minister, Mr Narendra Modi, Finance Bill 2016 is
expected to be enacted into a law latest by May 2016.
290  Journal of Financial Regulation

of the process), having due regard to their independence (objectively defined in the
Bill 2016) and expertise in matters relevant to the monetary policymaking.
Additionally, fixing their tenure to four years without any scope for reappointment
or grant of an extension of tenure bereaves them of any politically motivated reward
(reappointment/tenure extension) or deterrence (punitive dismissal).
MPC will determine the policy rate (repo rate) that will bind the RBI. Each mem-
ber in the MPC will have one vote, with the Governor enjoying a second and casting
vote for tie-resolution. Minutes of each MPC meeting, including the voting pattern
and the statements of individual members while voting for/against a resolution, are
to be published with a lag of two weeks. Transparency in publicly disclosing the indi-
vidual statements and voting pattern of all members of MPC will diminish the possi-
bility of group thinking and will foster public accountability of even GoI-appointed
external members. The responsibility of decision-making, and with it, the internal

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(organizational) and external (political) pressures ancillary to decision-making au-
thority will also be distributed from the individual RBI Governor to all the members
of MPC.
Adopting a less controversial stance than the IFC 1.0; while the Finance Bill 2016
allows the GoI to express its views in writing to the MPC (if necessary), it does not
mandate the MPC or the RBI Governor to abide by such views. It, however, em-
powers the GoI to remove from MPC any external member who, inter alia, in the
opinion of the Central Government, so abused his position as to render his continu-
ance in office detrimental to the public interest.7 Howsoever unlikely, it is neverthe-
less realistic to envisage that the GoI may seek to exert political influence on external
members by threatening to oust the member unwilling to toe the government line
by alleging an abuse of position by him/her. Therefore, it is important that, even if
power to remove external members of MPC is retained by the GoI (to truly make
them external to the RBI), grounds of their removal are not evasive (like, the abuse
of position or detrimental to public interest) rather, definite and worded unequivo-
cally, such that the GoI is unable to fire a member only because he voted in non-
compliance to views expressed, in writing or otherwise, by the GoI.

7 Finance Bill 2016 s 45ZE(1)(h).