Home / Opinion / Online Views /  FSLRC’s monetary policy myopia

The three main symbols of a country are its flag, anthem and currency. There are no scientific laws or theories regarding the first two, but with regard to the third, there has been a steep learning curve from the prolific research on the subject. The Financial Sector Legislative Reforms Commission’s (FSLRC’s) recommendations on monetary policy remind one of Gresham’s law that bad money drives out good money. In this case, the FSLRC, which has the laudable objective of enhancing accountability and independence for the Reserve Bank of India (RBI), has in its recommendations made it extremely difficult for RBI to achieve those objectives.

The FSLRC is of the opinion that the central bank must be given a quantitative monitorable objective by the government. Recognizing that price stability is a predominant objective worldwide, it nevertheless leaves it to the government to specify the goal. Let us for the moment suppose the specified goal is price stability. First, it is well known that monetary policy has long and variable lags and since the effect of monetary policy on prices has a lag of over 18 months, we can assess the action only a long time after it was taken. This makes accountability difficult to explain to the public. Central banks that have price stability as a goal usually announce intermediate targets to express future inflation developments in terms of currently observable variables—the exchange rate, credit or monetary aggregates. This enables economic agents to monitor how the central bank is faring with regard to its objective. In India, it is difficult to suggest variables that are closely associated with future price developments.

Second, central banks can only affect long-run inflation that has its antecedents in monetary phenomena. However, there are temporary deviations from price stability which it cannot be held accountable for—those arising, for instance, from changes in labour costs, or the sudden international rise in coal prices that raise the cost of power. No central bank can be held accountable for such temporary deviations from price stability. Third, central banks have been indicating that changes in public expenditures and taxes and the associated deficits by governments with a view to stimulating the economy are non-monetary sources of inflation that make it difficult to achieve price stability.

The FSLRC has bypassed the tough task of explaining how temporary deviations from price stability and non-monetary shocks can be accommodated into a quantitative monitorable objective.

There is also the issue of how to empirically define price stability. The US Federal Reserve System does not provide a definition and the Bank of England expresses it in terms of headline inflation. In India, RBI has been publishing a measure of core inflation (essentially excluding energy and food, the wholesale prices of which it has no control over). However, for long now consumer price inflation, which is what the common man associates with the cost of living, has been consistently higher than wholesale core inflation. This has increased the risk that a central bank focusing on a subset of the basket of goods that a common man consumes is seen as being out of touch with reality, especially when there are persistent movements in the prices of commodities that have been excluded from the core measure of inflation.

The FSLRC also recommends that the monetary policy committee (MPC) have eight members. In addition to the governor of RBI and an executive member of the board of RBI, there will be five external members, two to be appointed by the Union government in consultation with RBI governor, and three by the Union government. In addition, a representative expressing the views of the ministry of finance will participate but not have voting rights. The ostensible reason for having so many external members is to avoid the possibility of group-think within the central bank. But the FSLRC does not consider the possibility that the five external members who would represent the government may also be victims of group-think about what the government will like to implement.

At a conceptual level, the greatest difficulty with this FSLRC recommendation is the following—the central bank is to have no goal independence as its objectives will be set by the government and, yet, it will also not have operational independence as the MPC will be stacked with government appointees. It is usual that when you set a goal for an organization, you delegate responsibility to the head of the organization with operational and instrument independence so that accountability can be demanded. Instrument independence is important to insulate the central bank from the myopia of politicians who would like to have an expansionary policy before an election—a temptation that the FSLRC flags as contributing to macroeconomic fluctuations. It may be argued that of the 12 members of the Federal Open Market Committee in the US, seven are from the board of the Fed who have to be appointed after confirmation by the Senate. However, the majority of these seven do not have a background of being full time government officials and are in fact eminent academics. But more importantly, these seven are appointed for a 14-year term, which insulates them from political pressure. The terms of the governor and deputy governor at RBI has been a huge source of friction with the ministry of finance and has been a source of the unanchoring of inflation expectations in the country. The FSLRC ought to have protected the independence of RBI by recommending long appointment periods for members of the MPC—say 14 years with one term beginning every two years.

Errol D’Souza is a professor of economics at the Indian Institute of Management, Ahmedabad.

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