An IMF paper has raised question marks over the ability of the Reserve Bank of India to target inflation through monetary measures, saying the size of the formal financial sector is small in India and may undermine the effectiveness of interest rate changes on aggregate demand.
The IMF working paper assumes significance as the RBI has recently implemented an inflation-targeting regime that requires it to hit publicly announced targets for retail inflation, based on consumer price index, PTI reported.
Under the new dispensation, RBI will be required to meet a retail inflation target of 4%, plus or minus 2% over the next five years.
The interest rate from the next policy, due on October 4, will be decided by a six-member monetary policy committee instead of the central bank governor.
“In the absence of effective and reliable links between the policy instruments controlled by the RBI and aggregate demand in the Indian economy the public may lack confidence that the RBI is able to deliver on its announced inflation target, making the target more difficult (and costly) to achieve,” said the IMF working paper—‘Monetary Transmission in Developing Countries: Evidence from India’.
It said that careful studies of the effectiveness of monetary transmission in low-income countries have often found monetary policy effects that are counter-intuitive, weak, and/or unreliable.
“On the other hand, the small size of the formal financial sector in India would tend to undermine the effects on bank lending rates on aggregate demand,” said the paper authored by Prachi Mishra, Peter Montiel and Rajeswari Sengupta.
According to the paper, in the case of India, the response of the exchange rate to monetary policy shocks is in the right direction but the magnitude is very small.
Contrary View
The country’s economic recovery is expected to accelerate in the long-term on the back of rise in purchasing power, consumption growth and monetary policy easing, while inflation is seen below 5% over the next two years, says a Morgan Stanley report.
“We believe this will be a longer duration expansion cycle with GDP growth expected to accelerate and inflation expected to remain at or below 5% over the next two years,” Morgan Stanley said in a research note.
According to the global financial services major, the recovery in the Indian economy will be led by domestic demand, with factors like consumption, public capex and foreign investment playing the key part.
Five factors that will drive consumption growth sustainably higher going forward include, sustained moderation in inflation and improvement in purchasing power; trailing monetary policy easing and expectation of more easing; pay commission-related wage hikes for government employees; pick-up in job growth; potential improvement in the rural sector if the weather becomes supportive.
Though the RBI has highlighted that risks to inflation trajectory could emanate from food prices, impact of 7th Pay Commission and possible impact from GST, Morgan Stanley believes that risks from these remain manageable.
