Raghuram Rajan’s game-changing tenure

As expected, the last policy review under Raghuram Rajan was a non-event, but monetary policy under his watch has gone through a rather eventful journey in the past three years. The policy architecture, as well as the way it is conducted, is set to change for the better. As Rajan’s term comes to an end in a few weeks, it is important to recall the circumstances in which he took over as the governor of the Reserve Bank of India (RBI) about three years ago. India was struggling to restore policy credibility, was behind the curve in the fight against inflation, and its response to the 2013 rupee crisis was confused.

Soon after taking charge, Rajan in his very first statement announced the constitution of a committee under deputy governor Urjit Patel to suggest ways to strengthen the monetary policy framework. As Rajan now prepares to return to academia, he should be satisfied by what the RBI has been able to achieve in the past three years. The government also deserves credit for reducing the fiscal deficit and accepting the new monetary policy framework. Last week, it formally notified the inflation target for the next five years under the new framework. The RBI will now work to keep inflation based on consumer price index at 4%, with a band of two percentage points on both sides. This reasonably large band will provide the necessary flexibility to work with short-run issues such as those related to agricultural production, data limitation and developments in the foreign exchange market, without compromising the primary objective of maintaining price stability. To complete the process, a monetary policy committee (MPC) will now have to be constituted to decide policy rates. The new framework will not only make monetary policy more credible but also predictable. And the migration to this framework for monetary policy is undoubtedly Rajan’s most defining contribution to policymaking as governor of the RBI.

His tenure at the RBI also witnessed changes in other aspects of the monetary policy. The most recent change was to move towards a new liquidity framework. The idea is to eliminate the structural liquidity deficit from 1% of net demand and time liabilities in the system to a more neutral level. Although RBI has not given any timeline, completion of this process should lead to better transmission of policy rates. Rajan also introduced term repos to infuse liquidity in the banking system, which helps in better pricing of credit.

One of the challenges that RBI was facing when Rajan took over was a sliding currency. To overcome this, the RBI opened a swap window for banks to attract fresh foreign currency deposits which can be used to augment foreign exchange reserves. Now that those deposits are slated to mature, the central bank has done the right thing by buying foreign currency in the forward market so that volatility and depletion in reserves can be avoided. Meanwhile, the Rajan-led RBI has also accumulated record foreign exchange reserves. This has added to the stability of the Indian rupee even as a number of other emerging markets have seen high volatility in their currency markets due to global factors in recent times.

Rajan also leaves behind another legacy as a consequence of the shift to the new framework for monetary policy—the government will not be able to pressure the governor on policy rates as decisions will now be a collective responsibility of the MPC. This will enhance the autonomy and independence of the central bank. Hopefully, this will also reduce friction between the government and the RBI.

Now that the new policy framework is in place, apart from constituting the MPC at the earliest, the government will have to work towards creating conditions that will help the RBI maintain inflation close to the target. There are still unresolved supply-side issues that can affect inflation outcomes. The government would also do well by moving forward on the fiscal consolidation path as it is consistent with the objective of price stability. It will not help anyone if the RBI is unable to meet the target because of the fiscal stance of the government.

Will migration to the new monetary policy framework enhance RBI’s autonomy and independence? Tell us at views@livemint.com