A revolution in economic policy began in 1989, when New Zealand gave its central bank a formal inflation target combined with operational freedom to pursue that objective. Many other countries later adopted some variant of these reforms with some also moving the onus of policy from one individual to a committee.

The bold recommendations of the Financial Sector Legislative Reforms Commission (FSLRC) have to be examined against this backdrop. Two recommendations stand out. First, the Reserve Bank of India will be given a quantifiable target by the government rather than deciding its own goals. Second, while the Indian central bank will have the operational freedom to pursue its mandated goal, the final decision on policy will be decided by a monetary policy committee rather than the governor alone. A majority of the members of this committee will be appointed by the government.

Does this increase government leverage over monetary policy? The report of the commission released last week argues that its recommendations will actually help insulate monetary policy from political pressures, for example, because it is easier for the government to apply pressure on an individual central bank governor rather than an entire committee. However, the Indian situation provides ample room for scepticism, given the way institutions have been systematically destroyed by political appointments in recent years. It is not unthinkable that the government of the day packs the monetary policy committee with people who will bend to its will.

It is well accepted that the conduct of monetary policy has to be handed to technocrats who take a longer view, rather than politicians with incentives to think for the short term. It is precisely such operational independence that provides a buffer against what economists call the time-inconsistency problem, which in practical terms often means increasing tolerance for inflation in pursuit of growth. Such inflationary bias will be minimized only when there is minimal government leverage over monetary policy.

The problem is not with monetary policy by committee but its institutional details. The Federal Open Market Committee in the US has no outside members. The monetary policy committee in the UK has only four of its nine members from outside the Bank of England. What is proposed in India is different: a majority of the monetary policy committee will be government appointees.

India needs rule-based monetary policy, and in that sense we welcome the recommendations of the FSLRC. However, the Indian government is notorious for its fiscal profligacy, contempt for institutions and inability to think long term. It should have no say in the appointment of the monetary policy committee.

Is this the beginning of the end of independent monetary policy setting in India? Tell us at views@livemint.com

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