Monetary Policy Mandate in a Slowdown
Vistara, a hypothetical economy, has an inflation-targeting central bank. The statutory target is 4% CPI inflation with a tolerance band of 2–6%. The central bank must set the policy repo rate to achieve the target while 'having due regard to growth'. In the latest quarter, CPI inflation is 6.4%, driven mainly by food and fuel; core inflation is 4.1%; GDP growth has slowed from 6.0% to 5.2%; and the fiscal deficit is 5.6% of GDP. The monetary policy committee (MPC) has six members. Three members want a 25-basis-point rate cut to support growth; two want to hold; one wants a 25-basis-point hike. A rate cut would lower borrowing costs but could weaken the currency and raise import prices. The government has urged the MPC to 'support investment'. Under the statute, if inflation remains above 6% for three consecutive quarters, the MPC must submit a report to the government explaining the failure and the remedial action.
1. Is a 25-basis-point rate cut consistent with the MPC's statutory mandate? Give a reasoned answer.
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Not comfortably. The primary statutory target is 4% CPI, with a 2–6% tolerance band. CPI at 6.4% is above the upper band, so the MPC is already outside the zone in which it can treat inflation as on target. A cut is a demand stimulus: it lowers borrowing costs but can weaken the currency and raise import prices, which risks keeping inflation above 6%. The mandate does require 'due regard to growth', and growth has slowed to 5.2%; core inflation at 4.1% also suggests headline inflation is partly food-and-fuel driven. Those are arguments for caution, not necessarily for easing. A hold is the most defensible reading; a cut would require a strong explanation of how it remains consistent with returning inflation to 4%.
2. What does the 2–6% tolerance band imply about the MPC's obligation when inflation is 6.4%?
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The band converts the 4% target into an accountability zone. Inside 2–6%, the MPC has flexibility and need not react mechanically to every deviation. At 6.4%, inflation is outside the upper limit, so the MPC cannot treat the situation as business as usual: it must set policy to bring CPI back toward 4% and be ready to explain the breach. The band does not make 6% a new target; it defines the outer limit of tolerated deviation. Because 6.4% is only modestly above 6%, the case for an emergency hike is weak, but the case for easing is weaker still.
3. Assume CPI stays at 6.4% for three consecutive quarters. What must the MPC do, and how should that prospect affect its decision today?
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Under the stated statute, the MPC must submit a report to the government explaining the failure and the remedial action. That is an accountability mechanism, not a substitute for policy action. Prospectively, the MPC should avoid a cut now because a cut would make the three-quarter breach more likely and would undermine the credibility of the report. The rational forward-looking choice is to hold or tighten modestly, while communicating that food and fuel shocks are being monitored and that core inflation at 4.1% is the medium-term signal. If the MPC cuts today and inflation remains at 6.4%, its later report would have to explain a policy choice that worked against the target.