How to make the monetary policy committee work
PremiumWhat needs to be done now is to nurture the conditions for an independent MPC
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It is now a matter of time before interest rates are decided by a new monetary policy committee (MPC) rather than the Reserve Bank of India (RBI) governor acting on his own. The government last week announced the names of three economists who will be its nominees on the MPC. The central bank had earlier announced its three nominees as well. India will now be among the many countries where interest rates are set by a committee rather than an individual.
A lot now depends on how the MPC operates. There are several issues that need to be sorted out to ensure that the shift to the new system of deciding monetary policy is indeed worth it. First, all members of the MPC should have access to the same amount of information. What this means in practice is that the external members should have open access to the research done by central bank economists. Members of the old technical advisory committee have often in private complained about the lack of adequate data before meetings. An MPC secretariat may need to be set up for this.
Second, the group dynamics will matter. Experiments conducted by economist Alan Blinder show that committees take better monetary policy decisions than individuals. Yet, we must not ignore the risks from groupthink. There is little use of a committee if everybody thinks alike, or at least toes the official line. Governor Urjit Patel will have a big role to play in ensuring that discussions are open. Mervyn King at the Bank of England often allowed himself to be outvoted in the MPC. It would be especially welcome if the RBI members do not habitually vote as a block in the meetings. And the governor should try not to use his casting vote at least in the initial years.
Third, there should be a robust communications policy so that other participants in the economy have a clear sense of how MPC members are thinking about the economy. The US Federal Reserve provides dot plots on how various members of its rate-setting committee assess the trajectory of interest rates. The Indian central bank is not structured like its US counterpart. But there can be no doubt that the two major components of MPC meetings—the assessments of the state of the economy followed by the actual voting on interest rates—need to be communicated well.
The government will also have to let an independent MPC emerge. Its first signal has been positive, if you consider the three economists it has appointed as its representatives on the committee. A successful MPC should be able to deal with two persistent problems. First, there is the over-dependence on the economic judgement of one individual.
Second, there is the notorious time inconsistency problem that could emerge because of political pressures from New Delhi. However, that still leaves the larger problem of fiscal dominance over monetary policy untouched.
Indian monetary policy has entered a new era. The RBI has a formal inflation target that has been given to it by the political system. Interest rate policy will be decided by the MPC. There is now a formal process to fix accountability, since the MPC has to explain if the inflation target is missed for three quarters in a row.
The new institutional scaffolding is in place. The plumbing needs to be added. What needs to be done now is to nurture the conditions for an independent MPC. Economist Kevin Warsh, who wrote an influential report on the UK MPC in 2014, has pointed out: “Understanding the institutional dynamics inside monetary policy committees is likely as consequential to sound policy decisions as the skill of the people who lead the committees and the remits they are obliged to follow."
Warsh has also argued that the design of the decision-making process is especially important when there is a regime change in the data or in the policy paradigm. India is arguably at such a juncture right now.
It seems like the long battle against high inflation is coming to a close. And there has been an important shift to a monetary policy with a formal nominal anchor.
Governor Patel needs to take the lead in nurturing the first MPC in India so that the change to the new system is not cosmetic.
What will the central bank need to do to institutionalize the MPC? Tell us at views@livemint.com
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