The Parliament passed the Finance Bill 2016 to make amendments to the RBI Act, 1934. It paved the way for the formation of the Monetary Policy Committee.
Let’s start with a brief background. The Reserve Bank of India had appointed an expert committee in the year 2014 to reform the monetary policy framework in India.
It was led by Urjit Patel (Deputy Governor of RBI at that time)
The two major recommendations of the Urjit Patel committee were:
- The primary objective of the RBI should be to maintain inflation within a specific target (inflation targeting). It should abandon the practice of targeting multiple indicators like inflation, growth rate, exchange rate etc. This was adopted by India in 2016.
- A Monetary Policy Committee should be constituted to set India’s monetary policy.
How was Monetary Policy decided in the older system?
The RBI Governor was solely responsible to take the monetary policy decisions.
The Governor took decisions in consultation with the Deputy Governor of RBI and the technical advisory committee (TAC). The role of the TAC was advisory in nature and the final call was that of the Governor.
Urjit Patel recommended that the monetary policy decisions should be taken by the Monetary Policy Committee. In other words, the benchmark interest rates like Repo rate etc. should be fixed by the Monetary Policy Committee (MPC) instead of the RBI Governor. (Read: Repo, CRR, SLR, Reverse Repo- Explained)
How does the Monetary Policy Committee (MPC) operate?
- The main objective of the Monetary Policy Committee is to maintain inflation target, set up by the Central Government, in consultation with the RBI, every 5 years. The current inflation target till 31st March 2021 is 4 % within a band of +/- 2 %. Hence, the upper limit of 6 % and the lower limit is 2 %.
- The MPC has six members. Three are representatives of the RBI and three of the Central Government.
- The monetary policy decision is taken on majority vote
- The RBI Governor has the casting vote in the event of a tie, that is, in case of a tie, he has to vote again.
- The three members who represent RBI are the Governor of RBI, the Deputy Governor of RBI and one executive officer nominated by the RBI.
- The other three members are appointed by the Central Government through a search committee. These members shall hold office for four years and are not eligible for reappointment.
- The search committee comprises of cabinet secretary, the secretary of the department of economic affairs, the RBI Governor and three experts in the field of economics/ banking nominated by the Central Government.
- The MPC meets at least 4 times in a year.
- The RBI publishes Monetary Policy Report every 6 months explaining the sources of inflation and also the forecasts of inflation for the period ranging from 6 to 18 months
- If the RBI fails to achieve its inflation target, it has to explain the reasons for the deviation and the corrective actions to be taken in the report.
What is the rationale behind forming the committee?
- In India, inflation is often the result of supply-side factors like poor monsoon etc. But, RBI’s monetary policy is effective only against demand-side factors. Therefore, it becomes necessary for the Government and RBI to work together to combat inflation. The Monetary Policy Committee which has representatives from both the RBI and the Government enables greater fiscal-monetary co-ordination.
- It enables the decision-making process in RBI to be more participative and transparent. The minutes of the MPC meetings are released on the RBI’s website.
- It represents different views on Monetary Policy.
- It also ensures continuity in the Monetary Policy framework even if a new RBI Governor is appointed,
- It fixes accountability as the committee will have to explain in case the inflation target is not met.
In conclusion, this move has brought India’s monetary policy framework in convergence with that of its global counterparts. To give examples from other countries, the benchmark interest rate in the USA (Federal funds rate) is decided by the Federal Open Market Committee and in England, it is done by the Bank of England Monetary Policy Committee.