MPC: Many is better than one

In October 2008, decorated economist and former US Fed chairman Alan Greenspan conceded that the presumption guiding his approach to monetary policy for 18 years was flawed. His determination to maintain a prolonged period of low interest rates, which many advised against, encouraged the bubble in housing prices and culminated in the recent financial crisis.

Though US monetary policy operated with a committee-based system at the time, it was not the one-person-one-vote system seen in most inflation-targeting countries today; the members collectively arrived at a consensus for each decision they made. Greenspan, due to his reputation and expertise, was able to wield influence over other committee members and therefore dictate the country’s monetary policy. The committee essentially broke down to an individual decision-maker.

The global financial crisis resulting from his policies revealed the pitfalls associated with an individual decision-maker. Today, all inflation targeting countries perform their monetary policy functions through a committee-based approach (either by a separate monetary policy committee, or by an existing committee in the central bank that also has powers to perform monetary policy), with the exception of New Zealand and India.

New Zealand, having pioneered inflation targeting, still places monetary policy in the hands of the central bank governor. This governor is free to implement monetary policy with independence from the government. The catch? He can also be dismissed for inadequate performance in achieving the pre-defined policy targets. Accountability is thereby ensured, despite the power to “veto” a decision on interest rates.

India, however, simply fell behind while other inflation-targeting countries embraced contemporary thinking. Governed by a 1934 British archaic law, the central bank gives its governor absolute power to dictate the country’s monetary policy, without any statutory mechanism for accountability. This is dangerous for two reasons. First, because even a well-intentioned and well-informed governor might be wrong at times, as demonstrated by the US Fed.

Second, because with each new governor, the country’s monetary policy becomes vulnerable to sharp and divergent changes based on change in leadership. In a monetary policy committee, only a small proportion of the decision-making unit would potentially retire or be replaced each year, thereby preserving a country’s monetary policy direction over time.

A committee-based approach brings diversity of views to the thinking process of any decision. The Reserve Bank of India (RBI), in its 2014 Urjit Patel committee report, recommended that monetary policy decision-making be vested in a monetary policy committee with both internal and external members. It further recommended that each committee member have one vote, and that the RBI governor have a casting vote in the event of a tie. Even the makers of the Constitution recognized the error in contaminating decision-making with human judgement, and mandated in that not one but at least five judges are required to make decisions on any case involving a substantial question of law in relation to interpreting the constitution.

With almost all inflation-targeting countries using some form of a committee-based approach to monetary policy, the international debate now focuses on the composition of the committee, and whether its members should be internal or external. Internationally, there is no common standard for committee composition. Members are classified as external based on if their role on the committee is part time; if their background is segregated from former connections with the central bank; and, most significantly, if they are appointed by the central bank or the central government. Many countries, including emerging market peers such as South Korea, Thailand and Chile, have a majority of external experts appointed by the central government in their monetary policy bodies.

Today, roughly 30 countries, including India, target inflation. Studying 25 of these countries (excluding Ghana, Armenia, Guatemala and Turkey) shows that 10 perform monetary policy without any external members. The remaining 15 all have external members, and only two of these have a minority of external members (namely the UK and Iceland). The central government, and not the central bank, appoints the external members in 13 of the 15 countries. These external members, though appointed by the central government, need not be government nominees. In the UK, for example, special provisions allow government nominees to attend and speak at committee meetings in a “non-voting” capacity.

If India were to move towards this structure, two concerns may arise. First, that the opinion of external members would reflect the opinion of the government that appointed them. However, as external members serve for the duration of their tenure and not that of the appointing government’s, the independence of their opinion is maintained. When a new government comes to power, it cannot remove the existing external experts appointed by the previous government. These experts continue to serve the central bank until their tenure is completed. Second, that a government-appointed majority of external members strips the central bank of its independence. This concern is easily addressed by a selection process that ensures external member appointment is at arm’s length of the central government, as in the case of appointments to regulatory agencies in the country.

A well-designed monetary policy committee consisting of many government-appointed external members could in fact diminish the influence of one individual while reinforcing the institutional capacity of the central bank as an institution, thereby making it more independent from the government, not less.

Sanhita Sapatnekar and Mohit Desai are consultants at the National Institute of Public Finance and Policy (NIPFP).

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