Monetary Policy Framework Agreement

The Monetary Policy Framework Agreement (MPFA) is a landmark accord between the Government of India and the Reserve Bank of India (RBI), signed on 20 February 2015, that formally established inflation targeting as the primary objective of India’s monetary policy. The agreement institutionalised a transparent, rule-based monetary policy system, replacing the earlier discretionary approach, and laid the foundation for the creation of the Monetary Policy Committee (MPC).
The MPFA marked a major shift in India’s macroeconomic management, aligning it with global best practices by clearly defining the goals, accountability, and operating procedures of monetary policy.

Background and Evolution

Prior to the MPFA, India’s monetary policy framework was primarily multi-objective, focusing simultaneously on growth, inflation, exchange rate stability, and financial sector health. The RBI used various monetary tools to balance these objectives, often without a formally stated target.
However, persistent high inflation between 2008 and 2014, especially in food and consumer prices, undermined growth and public confidence in monetary policy.

Key Milestones Leading to MPFA:

1. Urjit Patel Committee (2014):The Expert Committee to Revise and Strengthen the Monetary Policy Framework, chaired by Dr. Urjit R. Patel, recommended a transition to a Flexible Inflation Targeting (FIT) regime.
   It proposed:
   • Setting inflation as the nominal anchor.
   • Using the Consumer Price Index (CPI) as the primary inflation measure.
   • Establishing a Monetary Policy Committee (MPC) for decision-making.
2. Economic Survey 2014–15:Supported inflation targeting to ensure monetary stability and improve coordination between fiscal and monetary authorities.
3. MPFA Signed (2015):Based on these recommendations, the Government of India and RBI signed the Monetary Policy Framework Agreement on 20 February 2015, formalising inflation targeting as the central bank’s primary objective.
4. Amendment to the RBI Act (2016):The Finance Act, 2016 amended the RBI Act, 1934, to provide statutory backing to the MPFA and create the Monetary Policy Committee (MPC).

Objectives of the MPFA

The primary objective of the Monetary Policy Framework Agreement is:

“To maintain price stability while keeping in mind the objective of growth.”

This dual objective reflects India’s adoption of Flexible Inflation Targeting (FIT)—a system that prioritises inflation control while allowing flexibility to support economic growth and financial stability.

Key Features of the Monetary Policy Framework Agreement

1. Inflation Targeting:
   • The Central Government, in consultation with the RBI, sets a target for inflation once every five years.
   • The inflation target is expressed in terms of the Consumer Price Index (CPI).
2. Inflation Target (as per current notification):
   • The Government of India, through a notification dated 31 March 2021, retained the inflation target at:4% with a tolerance band of ±2%, i.e., a range of 2% to 6%.
   • This target is valid for the period April 1, 2021 – March 31, 2026.
3. Accountability of the RBI:
   • If inflation exceeds 6% or falls below 2% for three consecutive quarters, the RBI must submit a report to the Central Government, explaining:
     • The reasons for deviation.
     • The remedial measures to be taken.
     • The expected time frame for returning inflation to the target band.
4. Transparency and Communication:
   • RBI is required to publish a bi-monthly Monetary Policy Statement (MPS) explaining the rationale for its policy decisions and inflation outlook.
5. Monetary Policy Instruments:
   • The repo rate (policy rate) is designated as the single policy instrument to signal monetary policy stance.
   • Other tools (CRR, SLR, OMOs, etc.) are used to ensure liquidity alignment with the policy rate.

Establishment of the Monetary Policy Committee (MPC)

The Monetary Policy Committee (MPC) was constituted in September 2016 as a statutory body under Section 45ZB of the RBI Act, 1934, in accordance with the MPFA.

Composition of the MPC:

Decision-Making:

• Each member has one vote, and decisions are made by majority vote.
• In case of a tie, the Governor of the RBI has a casting vote.
• The MPC meets bi-monthly to decide the repo rate and other policy measures.
• The minutes of the meeting, including individual voting patterns, are published to enhance transparency.

Operational Framework

Under the MPFA, the RBI uses the repo rate as the primary tool for achieving the inflation target.

• Repo Rate: The rate at which RBI lends short-term funds to commercial banks.
• Reverse Repo Rate: The rate at which RBI borrows from banks, influencing short-term liquidity.
• Monetary Transmission: Changes in repo rate are expected to influence borrowing costs, investment, consumption, and ultimately inflation and growth.

This framework has transformed India’s monetary policy into a rule-based, transparent, and predictable system.

Impact and Achievements of the MPFA

1. Price Stability:

• The MPFA has anchored inflation expectations effectively, reducing CPI inflation from double digits (2010–2013) to an average of 4–5% in recent years.

2. Transparency and Accountability:

• The bi-monthly MPC statements and publication of voting records have enhanced transparency and credibility.

3. Improved Policy Coordination:

• The framework has strengthened coordination between fiscal and monetary authorities while maintaining the RBI’s operational independence.

4. Monetary Transmission:

• A unified policy rate (repo rate) has improved transmission, especially with the linking of loans to external benchmarks like the RBI’s repo rate.

5. Credibility of RBI:

• Clear inflation targeting has improved investor confidence and macroeconomic stability.

Limitations and Criticisms

1. Rigid Inflation Focus:
   • Critics argue that excessive focus on inflation may constrain policy support for growth during downturns.
2. Supply-Side Inflation:
   • India’s inflation is often driven by food and fuel prices, which are less responsive to monetary policy.
3. Transmission Lags:
   • The transmission of rate changes to lending rates remains imperfect due to structural issues in the banking sector.
4. External Shocks:
   • Global commodity prices, exchange rate volatility, and geopolitical factors can disrupt domestic inflation management.
5. Dual Mandate Challenges:
   • Balancing the twin objectives of price stability and growth remains complex, especially during crises like the COVID-19 pandemic.

Recent Developments

• The COVID-19 pandemic (2020–2022) prompted the RBI to adopt an accommodative stance, prioritising liquidity and growth while keeping inflation within tolerance limits.
• The Monetary Policy Committee continues to fine-tune the policy stance between “accommodative,” “neutral,” and “withdrawal of accommodation” based on evolving economic conditions.
• The retention of the 4% ± 2% target in 2021 reaffirmed the government’s commitment to the inflation-targeting framework.

Significance of the MPFA

• Institutionalises Monetary Policy: Provides a structured framework with clear objectives and accountability.
• Enhances Credibility: Strengthens investor confidence through rule-based decision-making.
• Improves Fiscal-Monetary Coordination: Clarifies the division of responsibilities between RBI and the government.
• Aligns India with Global Norms: Brings India in line with international best practices in central banking.
• Ensures Price Stability for Sustainable Growth: Anchors inflation expectations, a prerequisite for long-term economic stability.