In an interview to Bloomberg TV a few days after he announced the new Union budget, finance minister P. Chidambaram said in response to a question about interest rate policy: “I think the RBI should take comfort from what we have announced as the fiscal consolidation path and I am sure the monetary policy advisory committee will advise the governor appropriately.”
It was odd that the finance minister had signalled to the monetary policy advisory committee rather than governor D. Subbarao directly, especially since the latter has often taken decisions contrary to what the committee had advised him. Then came a Subbarao statement from Mauritius on 26 March: “India also needs to move towards a monetary policy committee structure… For that to happen there are some necessary conditions to be fulfilled and one of the necessary conditions must be more independence of central bank,” he was quoted as saying by Reuters.
The sudden talk about a powerless group of advisers makes more sense now: The report of the Financial Sector Legislative Reforms Commission (FSLRC) released on Thursday has proposed a radical overhaul of central banking practice in India—and an empowered monetary policy committee (MPC) is one of the central recommendations of the commission, which was set up to overhaul financial legislation. An earlier committee on financial sector reforms headed by Raghuram Rajan, now adviser to the finance minister, had also recommended an empowered MPC.
The FSLRC has drawn out an ambitious agenda that seeks to base Indian financial policy on a system of rules, as well as simplify the maze of financial regulation.
The FSLRC argues that its recommendations will reduce political interference in monetary policy as well as make the Reserve Bank of India (RBI) more accountable. Yet, there are also fears that the proposals will give New Delhi greater leverage over the Indian central bank, one of the few credible institutions in the country. These recommendations come in the wake of a spate of disagreements between the central bank and the finance ministry over the past decade.
Since the early 1990s, many other countries have moved the onus of fixing policy interest rates from an individual to a committee, so the FSLRC has taken a step in the right direction. Economist Alan Blinder has described the rise of MPCs as a silent revolution in the world of monetary policy. Even the decision to set up a “technical” committee of monetary policy advisers in India was seen as a tentative step in the same direction. Do these committees work? Some studies show that central banks with MPCs have a better record at controlling inflation, though there is no clear result as far as success in managing economic growth goes.
India could be on the verge of joining the revolution that Blinder spoke about.
It is not the suggestion to set up an empowered MPC that could spark debate, but the way it is constituted and its task defined.
The FSLRC, headed by B.N. Srikrishna, a retired judge, has recommended the creation of an MPC “that would determine the policy interest rate”. The committee will be headed by the head of the central bank, but five of its seven members will be outsiders. The finance ministry will also send a representative, but without a vote.
That means the majority of members will come from outside the RBI—and they will be appointed by the government. In the UK, the nine-member MPC has only four external members. The US Federal Open Market committee—a quasi-MPC—has no outside members. In effect, the RBI governor will no longer have sole control over monetary policy, though he will still have the power to “override the MPC in exceptional circumstances”.
The FSLRC report justifies this change on two counts. First, by handing over monetary policy to a committee, it reduces the chances of political pressure on one individual—the RBI governor. Second, “the staff of the central bank report to the head of the central bank and face obvious conflicts of interest in voting independently. Additionally, these multiple members from one organization raises the possibility of group think.”
The other significant FSLRC recommendation on monetary policy is that the objectives of such policy will be decided in “consultation” with the government, giving New Delhi a far bigger role than now in monetary policy. This will be a quantitative target that must be met, and what constitutes failure to do so will also be defined in a public document, a move that could replace the current ambiguous messages that often confuse the money markets.
The fashion in global central banking till now was that this quantitative target would be an inflation target, but the FSLRC now seems to have taken on board what has happened in the world since 2008.
It will be an inflation target in most years, but the government will have the flexibility to change the target to something else, such as a fixed exchange rate or nominal GDP (as the emerging group known as the market monetarists suggest). However, the onus of deciding what the target should be will be decided by the government, and not the central bank. “The commission believes that the central bank must be given a quantitative monitorable objective by the Central government for its monetary policy.” (italics added)
The FSLRC recommendations are far reaching in their impact, though they seem to give the government a far greater say in monetary policy than it had till now.