Comment on the Revised Draft Indian Financial Code

My comments on the draft IFC which I sent to the FSLRC:

I appreciate the hard work put in by the Commission to come up with a draft legislation that will aid greatly in enhancing the transparency within the financial system in India. This is a much needed bill and the formation of an MPC as an entity separate from the RBI and the Union Govt is a welcome step in this direction.

However, I wish to make one comment regarding the following clause in the draft code: 

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Chapter 65, Clause 255: 

“Inflation target for each financial year will be determined in terms of the Consumer Price Index by the Central Government in consultation with the Reserve Bank every three years.”

The resetting or review of the inflation-target every three years by the Central Government is undesirable for the following reasons, even if it is done in consultation with the RBI:

  1. Monetary policy actions have indeterminate lags with respect to their effects being actually felt in the economy. A hard review timeline of three years is probably counter-productive and may lead to policy targets being based on noisy data
  2. A major channel through which monetary policy operates is through expectations of future inflation. Adding a three-year review adds uncertainty about the path of the real-rates in the future, especially at the review-tenor. This uncertainty, which is purely an artifact of the clause above, will add an unnecessary term-spread for borrowers in the markets.
  3. It takes time for inflation targets to be institutionalized and the market to adapt to them with savings, insurance and credit products – especially if the products are inflation-linked. The three-year review process will hinder the expansion and liquidity of such markets. Another disadvantage of this would be that market-implied measures of medium-term inflation – such as the breakeven inflation rate on index-linked securities – would be quite useless – which would not be beneficial for the MPC when setting rates.

While an assessment of the inflation target/range an economy should adopt may be necessary from time-to-time, especially for an emerging market like India, it is necessary to:

  • Let an independent body like the MPC decide the target – this will enhance the credibility of the monetary policy
  • Let the target be reviewed over a longer time-span – say 7-10 years – which would allow for short-term aggregate demand/supply shocks to dissipate enough so that potential output and output-gaps can be assessed accurately – based on which an inflation-target/range may be determined