The Reserve Bank of India (RBI) has requested the government to extend by another 5 years the mandate to keep inflation at 4% (+/-2%) i.e. to keep consumer price index (CPI) between 2% and 6%.

However, its recommendations to the government are silent on the powers of the Monetary Policy Committee (MPC) which has in the last few months become toothless because the excessive liquidity has made repo rate irrelevant to overnight rates.

However, the RBI also has other pressing problems. It has been buying bonds to help the borrowing program of the government. It is also buying dollars to keep the rupee from appreciating. This is creating excessive liquidity which in turn can create other problems like high inflation or mispriced lending. Which is why the RBI has requested the government to issue market stabilization bonds to soak up the liquidity. Government hasn’t yet provided because that will mean more interest cost for the government.

Speaking to CNBC-TV18, D Subbarao, Former Governor of RBI said that 4% (+/-2%) inflation framework has worked well and must be continued. He also said that RBI’s report provides abundant justification for the 2-6% inflation target.

“Ideally in an inflation targeting framework, you should identify target of inflation which supports growth and employment. We know that the relationship between growth and inflation is non-linear. If inflation is below a certain level, it supports growth, but if inflation goes above a certain rate, then it is inimical to growth.

So, you want to find that inflexion point where it provides maximum support to growth and employment. But that is very difficult to find and practice analytically and that is the reason why the RBI has put out a working paper and also provided significant and substantive justifications for the 4% inflation target. I think the 4% has served has well and I think we should stay with it because any change or any relaxation might be a huge credibility challenge about why the RBI or the government is asking for a more relaxed target,” he said.

He also believes that the MPC should be given power to decide on reverse repo rate. “I believe that the MPC must have control over both repo rate and the reverse repo rate. The reason I say is, the interest rate structure in the economy is determined both the by the reverse repo rate as well as the repo rate. It is the total combined interest rate structure that determines inflation. The MPC is accountable for delivering on the inflation target. So, as long as the MPC is accountable for delivering on the inflation target, I believe the MPC must have powers to decide both on the repo rate as well as the reverse repo rate,” he said.

Subbarao said that he would advise government to let RBI issue market stabilisation (MSS) bonds.

“If I were the finance secretary today, I would advise the finance minister to approve the RBIs request for MSS. The government’s reluctance or disinclination to approve an MSS facility for the RBI might be because there is a cost directly on the Budget. To believe that they can avoid the cost of intervention in the forex market by denying MSS facility, I think is misguided and misinformed,” he said.

He also said the time has come for privatisation of PSU banks. However, he said that it would be a bad idea to sell the weaker banks first as they are likely to be saddled with legacy issues.

For full interview, watch the video.

(Edited by : Aditi Gautam)