By Dipak Kurmi
In the ever-evolving landscape of India’s monetary policy, the Reserve Bank of India’s (RBI) new Governor, Sanjay Malhotra, is set to chair his first Monetary Policy Committee (MPC) meeting on February 5-7, 2025. As he steps into his role, one of the first questions he might ponder is the basis for the 4% inflation target set by the central bank. To answer that, we must travel back in time to the 1980s, a period when the country’s economic thinking began to shift dramatically, laying the foundation for the modern framework of inflation management. Specifically, the answer lies in the 1985 report by the Chakravarty Committee—a report whose recommendations, four decades later, continue to resonate in the fabric of India’s monetary policy.
The Chakravarty Committee, constituted under the leadership of Sukhamoy Chakravarty in 1982 by then-RBI Governor Manmohan Singh, was tasked with reviewing the functioning of India’s monetary system. At a time when the Indian economy was still under the heavy influence of planning and state control, the committee was asked to examine the linkages between fiscal policy, monetary policy, and the banking system. The context in which the committee worked was crucial to understanding its recommendations, especially regarding inflation.
To grasp the significance of the Chakravarty Committee’s insights, it is essential to understand the prevailing macroeconomic ideologies of that time. After the Second World War, Keynesian economics largely dominated global economic policy. Keynesian theory emphasized boosting growth and lowering unemployment, often at the cost of inflation control. The development of the Phillips Curve further entrenched the idea that a trade-off existed between inflation and unemployment. Policymakers believed that they could reduce inflation by tolerating higher unemployment and vice versa.
However, not all economists subscribed to this view. In 1968, the renowned economist Milton Friedman challenged the Keynesian paradigm, arguing that the trade-off between inflation and unemployment could only be temporary. According to Friedman, higher inflation would eventually lead to higher inflation expectations, setting off a cycle of inflation that could not be controlled merely through increases in unemployment. The economic turmoil of the 1970s, marked by both high inflation and rising unemployment, proved Friedman’s hypothesis correct, and the world shifted from Keynesianism to monetarism. Monetarism emphasized that controlling the money supply was the key to controlling inflation, and the role of central banks was to regulate the growth rate of money supply to keep inflation in check.
In this context, the Chakravarty Committee’s recommendations became pivotal. The committee noted the troubling rise in India’s inflation rate during the 1970s and 1980s, which averaged around 9% from 1971 to 1985, compared to 4% during the previous two decades. A primary driver of this inflation was the government’s increasing reliance on deficit financing, particularly through the issuance of ad hoc Treasury Bills (T-Bills) to the RBI, which, in turn, inflated the money supply. Despite higher inflation, the government continued to maintain administered interest rates, which prevented the typical market adjustments that would have occurred in a more liberalized system.
The Chakravarty Committee argued that inflation could no longer be ignored in the pursuit of economic growth. It emphasized that price stability should be a core objective of India’s monetary policy, alongside other national goals such as growth and employment. The committee recommended that the government target an annual increase of no more than 4% in the Wholesale Price Index (WPI). This target was not arbitrary but was designed to ensure enough flexibility for relative prices to adjust in response to changing investment priorities and technological developments.
The committee also recognized the importance of limiting deficit financing and recommended that the government finance its expenditures through public savings, rather than relying on the RBI. By tapping into the savings of the public and reducing reliance on central bank funding, the committee believed that inflation could be better managed. Moreover, it suggested that interest rates should be determined by market forces, not government control. In the committee’s view, the RBI and the government needed to develop an active secondary market for government securities, thus moving borrowing away from the central bank and toward the public.
Perhaps the most influential recommendation of the Chakravarty Committee was the call for the RBI to adopt a policy of monetary targeting. By the mid-1980s, the RBI began targeting money supply, specifically M3, in a bid to control inflation. However, as the economy evolved and financial markets became more complex, it became clear that simple monetary targeting was not enough to maintain stable prices. The rise of financial innovations and alternative forms of money made it increasingly difficult to measure the money supply accurately.
Thus, the system of monetary targeting gradually gave way to interest rate-based policies, a shift that was further reinforced by the global movement towards inflation targeting in the 1990s. New Zealand was the first country to experiment successfully with targeting inflation through interest rate adjustments. This idea gradually spread to other countries, including India, which adopted a multiple-indicator approach to monetary policy in 1997, before fully embracing inflation targeting in 2016.
The 1991 economic reforms were another turning point, as they carried forward many of the recommendations from the Chakravarty Committee’s report. Finance Minister Manmohan Singh, who had played a key role in both the committee’s formation and its subsequent implementation, continued to push for liberalization. The government gradually moved away from deficit financing, allowing for market-driven interest rates, and established a more robust government securities market. This paved the way for greater policy flexibility and a more modern, efficient financial system.
The most recent evolution in India’s monetary framework came in 2014, with the establishment of the Urjit Patel Committee, which recommended a formal inflation targeting framework for the country. The committee’s recommendations were adopted by the government, leading to the introduction of a 4% inflation target with a tolerance band of 2%. Remarkably, this target echoes the 4% recommendation made by the Chakravarty Committee nearly 40 years earlier, showcasing how the principles laid down by the committee continue to shape India’s economic policy.
Governor Sanjay Malhotra, as he steps into his role, will undoubtedly recognize the long evolution of India’s monetary policy, from the Chakravarty Committee’s early focus on price stability to the modern framework of inflation targeting. His challenge will be to steer the RBI through an increasingly complex global economic environment, balancing the need for growth with the need to maintain price stability. The 4% inflation target, which has been a cornerstone of India’s monetary policy since 2016, remains a testament to the foresight of the Chakravarty Committee and its continued relevance in shaping the country’s economic future.
The 4% inflation target that Governor Malhotra will oversee in his first MPC meeting is not a recent development, but rather the culmination of decades of economic thought and policy evolution. From the Chakravarty Committee’s recommendations in the 1980s to the inflation targeting framework established in 2016, India’s monetary policy has undergone significant transformation, shaped by both global economic shifts and local needs. As India navigates the challenges of the 21st century, the lessons from these past reforms will continue to guide the path forward.
(The writer can be reached at dipakkurmiglpltd@gmail.com)
