It is election season around the world and politicians of all hues are asking electorates to give them a mandate for change. In contrast, at central banks everywhere the buzz is all about a change of mandate.
Illustration: Jayachandran / Mint
Broadly speaking, central bank mandates fall into three categories. The hierarchical mandate is one with a primary goal (e.g., inflation targeting) followed by other goals. The Bundesbank and its successor, the European Central Bank (ECB), is the most famous example of this type. The dual mandate bank is one with two co-equal primary goals (e.g., price stability and maximum employment,) with the US Federal Reserve being the most notable example. The third kind (my definition) is a central bank that pretty much has a vague mandate (currency and stability, flow of credit and the like). The central banks of Canada, India and China are examples of this third type of mandate.
Timing and legacy have played a role in the establishment of these mandates. Born in the dying embers of World War II and with the raw memory of hyperinflation in the Weimar Republic, the Bundesbank became the very symbol of “inflation fighting”. When the Federal Reserve Act was promulgated in 1913, the US was a developing country with a largely agrarian base. The leading central banks of the time were privately owned institutions and, in addition to the normal functions of money and credit, served as lenders of last resort. In its first avatar, the Fed was conceived as a public-private partnership (recognize that term, anyone?). As the inherent conflicts of an inflexible gold standard became apparent to a democratic country, political considerations dictated that both inflation and employment were important. The Reserve Bank of India (RBI) was born in 1935 as a private institution and subsequently nationalized in 1949, a year before India became a Republic.
These institutions have evolved with time and the impact of significant economic events of the last century. The Great Depression, Bretton Woods, stagflation, hyperinflation of Latin America and the Asian crisis have all left a mark on them. In the last 20 years or so, inflation-targeting banks were considered the benchmarks to beat. An uncluttered, focused objective was supposed to give market participants a clear picture of the path forward. Several existing central banks made amendments to get closer to this “advaita” philosophy (Brazil), and new ones were born with the single objective (Afghanistan). By academic persuasion Ben Bernanke is an inflation targeter. From Chile to the Philippines, the consensus, most particularly the Washington consensus, sought to prescribe inflation fighting as the solution to all economic ills.
Today, pragmatism reigns. In monetary policy, the ability of central banks to duck and weave and to allow creative solutions to help their moribund economies is now considered a great positive. Dual-mandate and vague-mandate banks have, generally speaking, been able to move quicker and with a wider range of ideas than single-mandate banks (the Bank of England, a single-mandate bank, may be the exception).
A parallel debate is about the role of central banks in combating asset inflation. “Prevention (of asset bubbles) is the best way to minimize costs for society from a longer-term perspective,” said Otmar Issing, former chief economist for Deutsche Bundesbank and ECB, in a 19 February 2004 Wall Street Journal op-ed. “Most exceptional increases in prices for stocks and real estate in history were accompanied by strong expansions of money and/or credit.” Famously, Alan Greenspan was on the other side. “It would be very desirous to find a way to suppress asset bubbles,” he said. “But the trouble is, it has never been done and I am very sceptical that it will be done.” Perhaps the last word on this should belong to Paul Volcker, who seems to suggest that vigilance and certain ability to be pragmatic is the best way: “The first and most fundamental lesson of the crisis is that future policy should be alert to, and take appropriate measures to deal with, persistent and ultimately destabilizing economic imbalances. I realize that is a large and continuing challenge of international as well as domestic proportions, but it is the essence of prudent economic management.”
So, what’s a central bank to do? When recession, lack of credit flow and unemployment threaten, it needs to combat it aggressively with whatever tools it has at hand (advantage vague mandate). But when inflation is beginning to gallop, the market begins to look for a singular focus on inflation targeting (advantage single mandate). I am willing to wager a tidy sum that one consequence of the credit crisis of 2008 will be that received wisdom on central bank mandates will address the failures of both ECB and the Fed’s methods. I think the Fed’s mandate will evolve to include “assets” as a category to be watched for inflation, and that ECB will need to add employment or growth in some way to its mandate.
What of India? RBI’s mandate is to “...regulate the issue of bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.” Huh? That sounds like a literal translation of an ancient Sanskrit text. And like any ancient Indian word, it can be suitably interpreted by the reader. But its very vagueness may be a virtue in these difficult times. It allows the bank to cut/raise interest rates, change the cash reserve ratio, defend the currency, condone spending, counteract spending, establish prudential norms for lending to specified sectors, change bank risk weights and so on. One day RBI will have to accept that inflation fighting needs a more prominent mention in its objectives. Until then, it has licence to use the current mandate to India’s advantage.
Narayan Ramachandran is managing director and country head, Morgan Stanley, India. These are his personal views. Comments are welcome at email@example.com