An early attack on independence of RBI’s monetary policy committee
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The new monetary policy framework that India has accepted is premised on a clear division of labour. The government representing the people of the country gives the Reserve Bank of India (RBI) a formal inflation target to pursue. The central bank then gets the operational freedom to meet the inflation target as it thinks best. Is this arrangement already under threat?
The Union finance ministry has summoned the members of the monetary policy committee (MPC) to New Delhi to discuss government views on interest rate policy. The meeting will be attended by chief economic adviser Arvind Subramanian, principal economic adviser Sanjeev Sanyal and economic affairs secretary Shaktikanta Das. There will be two sessions: one with RBI representatives in the MPC and then one with the outside members, a curious arrangement. In an interview to Business Standard last week, Subramanian said that such meetings would be an attempt to “give structure to the government inputs to the MPC”.
The RBI Act does give the government the power to give directions to the central bank in the public interest, after consultation with the governor. The idea is that the government as the sovereign will have leverage over central bank decisions on the occasions when public interest is threatened. It is not a blanket permission to interfere with regular decision making on monetary policy.
Another section of the RBI Act also says the government is empowered to convey its views in writing to the central bank, which again is quite different from regular meetings in the ministry before every MPC decision. We worry that these meetings, as they become regular features in the policy calendar, will eventually become occasions for putting pressure on MPC members. They should not buckle under.
Relations between the Union finance ministry and the RBI have been tense for many years now. The mutual respect we saw between Manmohan Singh and C. Rangarajan, and then Yashwant Sinha and Bimal Jalan, is now a distant memory. Interest rate policy has been one of the flash points. Subramanian himself has often publicly said that monetary policy is too tight despite the fall in inflation. He would like lower interest rates. The MPC has, meanwhile, changed its outlook from accommodative to neutral.
The core underlying question is this: Should we see the RBI as an arm of the government or should it be seen as an independent constitutional body like the Election Commission? The former is a view that fits in well with the interventionist mindset of the 1970s, while the latter is more in tune with a liberal economic framework.
There is an important issue to be considered against this backdrop. The task of a central bank to stabilize inflation expectations over the medium term may be in conflict with the political incentives of an incumbent government over the short term. In a landmark 1985 paper, Kenneth Rogoff had explained why a government with weak credibility on inflation would do well to shift the job of maintaining price stability to an independent central bank that gives more weightage to inflation than the government does.
The problem of incentive incompatibility can be stated in a more direct way as well. A government may give the central bank a tough inflation target but then undermine it through either its fiscal policy or by bringing pressure on MPC members to keep monetary policy too loose. The RBI will be hung out to dry if the inflation target is not met. The finance ministry will have no responsibility for the failure. The concept of time inconsistency is surely not unknown to the economists in the finance ministry.
The general principle is that finance ministry officials should not even make public statements about interest rate policy. The cacophony of voices on interest rate policy during the last years of the second Manmohan Singh government—the finance minister, the finance secretary, the chief economic adviser, the deputy chairman of the Planning Commission, the head of the advisory council to the prime minister—not only undercut the authority of the RBI governor but also confused the bond markets.
One of the stellar achievements of the Narendra Modi government is the creation of a new institutional structure for the Indian economy—the MPC for monetary policy, the GST council for indirect taxation, the Insolvency and Bankruptcy Board of India for corporate exits, and now, hopefully, a fiscal council as a budget watchdog. These institutions need to be nurtured with the right institutional culture, especially in the early years, given the path dependence of institutional trajectories. Operational independence will thus be critically important. The idea that MPC members should go to the finance ministry before every meeting is thus a bad idea.
This newspaper had strongly opposed the suggestion that government officials should be either members of the MPC or sit in as observers. The “structured” meetings with finance ministry officials is, similarly, an idea that needs to be junked.
Should the members of the MPC meet government officials before making policy decisions? Tell us at firstname.lastname@example.org