The Economist once wrote that the only good central bank is the one that can say no to politicians. On Monday, the cautious D. Subbarao, governor of the Reserve Bank of India (RBI), came as close as he could to saying that.
In his comments at the meeting of the central bank governance group in Basel, Subbarao, among other issues, argued for creating a formalized monetary policy committee (MPC) architecture. The situation today is that while the governor is advised by a technical advisory committee, the final call on setting the policy rate is his alone to make. A proper MPC—which should include the governor, the four deputy governors along with outside experts—would give binding advice on setting of policy rates to the governor. The RBI chief said a precondition for this was to get legally backed autonomy for the central bank, something that the RBI Act 1934 does not provide.
While RBI’s ability to steer independent monetary policy is, by and large respected, there is, however, a catch. Between the arm-twisting by the Union government that the RBI Act enables and legally backed autonomy, there is a wide and opaque space for jousting between the government and the bank. The exact balance depends on circumstances. This is hardly the stuff of rule-based monetary policymaking.
The case for independent central banking rests on one fundamental economic reality: in the long run, there is no trade-off between inflation and growth. And the conclusion is that there is no case for political decision making in this domain. In India, there is disbelief among politicians that this is so. It is only for the past 14-15-odd years that the central bank has been allowed to set policy rates without extraneous considerations. Left to their devices, finance ministers would stitch together a patchwork of short-term trade-offs between growth and inflation and call it policymaking. With frequent elections at the state and Central levels, this can only lead to economic chaos and it has for long.
So far, the Union government has never seriously implemented rule-based fiscal policy. The Fiscal Responsibility and Budget Management Act was jettisoned at the first opportunity in the name of crisis management. If, however, the central bank were to have an MPC framework with formal autonomy, things could change. Once the central banks set policy rates only with a view to fighting inflation, it could potentially nullify the gains the governments hope to make politically by reckless spending. The short-term growth inflation trade-offs could become history. The Union government is unlikely to listen to Subbarao, but a future reform-minded government could well undertake the necessary steps.
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