Monetary Policy Framework — Inflation Targeting

3.1 Evolution of Monetary Policy Framework

Pre-2016 — Multiple Indicators Approach: RBI used multiple indicators — exchange rate, credit growth, inflation, growth — without a single overriding mandate. This created policy ambiguity and unpredictable rate decisions.

2013 — Urjit Patel Committee: Recommended adopting flexible inflation targeting with CPI headline as the target variable, and constituting an independent MPC.

2016 — Formal Inflation Targeting: The RBI Act 1934 was amended (Finance Act 2016) to formalise the new framework. Key changes included:

• A formal inflation target of 4% CPI ± 2% tolerance band (i.e., 2%–6%)
• Constitution of the Monetary Policy Committee (MPC) with 6 members
• Accountability mechanism: if CPI exceeds 6% for 3 consecutive quarters, RBI must write to the government explaining the failure and corrective action

3.2 Monetary Policy Committee (MPC)

Composition:

1. Governor, RBI (Chairperson, has casting vote)
2. Deputy Governor in-charge of Monetary Policy
3. RBI-nominated Executive Director
4. 3 External Members (government-nominated, 4-year terms, no re-appointment)

Meeting schedule: Every 2 months (6 meetings per year). Decision by majority vote; minutes published 14 days after meeting; individual voting records disclosed.

2024-25 Inflation Context:

• CPI inflation averaged 4.7% in 2024-25 — within the tolerance band
• Food inflation spiked (vegetables, pulses) — drove headline up to 5.7% in Oct-Dec 2024
• Core inflation (ex-food, ex-fuel) remained subdued at ~3.5%
• With inflation under control, MPC shifted to rate cuts in early 2025

3.3 Transmission of Monetary Policy

The Transmission Challenge: Interest rate cuts by RBI do not always reach borrowers quickly. The key transmission channels are:

• Bank Lending Rate Channel: Banks linked to EBLR (External Benchmark Lending Rate — repo-linked) since October 2019. RLLR = Repo + Spread. Transmission is now more direct than the earlier MCLR/base rate system.
• Asset Price Channel: Lower rates boost equity and housing prices, increasing the wealth effect.
• Exchange Rate Channel: Lower rates → capital outflows → rupee depreciation → export competitiveness but also import inflation.
• Credit Channel: Lower rates stimulate bank lending, especially to rate-sensitive sectors (housing, auto, MSME).

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