While broad-basing the decision-making process is welcome, the government must appoint independent individuals who have experience and the courage of their convictions as members of the proposed Monetary Policy Committee
The controversy provoked by the draft Indian Financial Code (IFC) released by the Ministry of Finance in July on the Monetary Policy Committee (MPC) has finally been put to rest with the Governor of the Reserve Bank of India and Ministry of Finance officials coming out with clear statements that there was no difference between the RBI and the government on the contours of the MPC.
There is also some indication that the Bill to amend the RBI Act to provide for monetary policy decisions to be taken by an MPC would be introduced soon in Parliament –presumably now in the winter session. Such an important amendment deserves to be debated separately in Parliament and not along with other changes on regulating the financial sector. Every central bank in the world has its own standalone legislation recognising its unique role as the issuer of currency and lender of last resort. It is hoped that parliamentarians will ensure that the sanctity of the standalone RBI Act is retained so that any measures to amend the RBI are independent and not included in an all compassing legislation on the financial sector like the draft Indian Financial Code seeks to do.
While the full details of the proposed MPC are not available, some details about it can be gleaned from statements by the RBI governor, Finance Ministry officials and media reports. From various press reports it is not clear whether there will be six or seven members and whether the majority will be from the RBI or will be external members. The Chidambaram formula, i.e. three members from the RBI and three appointed by the government with a casting vote by the governor, with no veto, seems to find favour with many. No details are available on whether the non-RBI members will be full time – drawing compensation – or the manner of their selection.
Significance of inflation targeting
As the RBI, acting through the MPC, is expected to be responsible and accountable for delivering inflation within a clearly defined range, it is necessary to understand the implications of having a clear inflation target for the RBI before discussing the role and composition of the MPC.
The Government of India (Ministry of Finance) and RBI agreed on February 20, 2015 to a monetary policy framework that will make managing inflation the key determinant in the central bank’s policy decisions. The agreement says the objective of monetary policy would primarily be to maintain price stability, while keeping growth in mind. There is a clearly defined target of managing inflation (CPI) in a band of 2% on either side of 4% – i.e between 2-6%. There is an implicit view here that inflation below 2% and above 6% puts growth at risk.
Earlier governors like Bimal Jalan , YV Reddy and D Subbarao followed a multiple indicator approach – though inflation was a very important objective. However, inflation targeting was not formally adopted for several reasons which Reddy spelt out in a recent lecture to the Association of Indian Economics and Financial Studies conference at University of Hyderabad in August 2015. First, there are supply shocks, which make it difficult to deliver on the inflation target within a meaningful range, especially when food and fuel formed a large part of consumption basket. The other reasons he mentioned are the weak transmission mechanism, no proven evidence that inflation targeting by itself rendered a better inflation record, and the complexity of the inflation/growth trade-off in a country undergoing structural transformation like India. As Dr Reddy states, the RBI – instead of a formal inflation target – set out an outlook for inflation in each monetary policy statement which served in some ways as a target under the circumstances. He described his approach to inflation at that time as “self imposed, indicative inflation targeting, consistent with global trends, and the compulsions of maintaining growth momentum.”
It is also important to note, as he does, that following the global financial crisis, there is more awareness of the limitations of monetary policy in managing inflation – and the tilt is towards flexible inflation targeting and an emphasis on reforms in the real sector to revive the economy. In other words, the jury is still out on inflation targeting. The Urjit Patel committee also recognises the difficulties involved.
Having said this, the actual range of 2-6% for CPI inflation set in the March 2015 agreement is quite wide and allows for flexibility. The main advantage with having an explicit target is that it sets inflationary expectations, which itself is a factor affecting inflation. As for the credibility of the RBI being eroded in the event of failure to achieve the target, ultimately the government of the day is always held responsible when inflation becomes intolerable, and the distinction between it and the RBI is too fine for the common person!
Why an MPC matters
Does having an MPC make the quality of decision-making better? In this respect, the merits of having a committee for deciding on monetary policy – at least at an advisory level – seem to be overwhelming. Subbarao believes the benefits include obtaining a wider perspective, making decisions more contestable, and bringing about greater accountability of its members. The current RBI governor, Raghuram Rajan cites three virtues. “First, a committee can represent different viewpoints and studies show that its decisions are typically better than an individual’s. Second, spreading the responsibility for the decision can reduce the internal and external pressure that falls on an individual. Third, a committee will ensure broad monetary policy continuity when any single member, including the governor, changes.”
It is not surprising that most countries have adopted an MPC. For India, Reddy constituted a Technical Advisory Committee for monetary policy in 2003 and this arrangement continues. Constituting a decision-making committee under the law makes us believe that it will be more accountable – but it also seems to suggest the links between monetary policy actions and outcomes are well defined and predictable and that monetary policy actions will have the intended outcomes. As this is a nebulous relationship given the difficulties of inflation targeting – especially considering the weak transmission mechanism – it is not very clear how accountability will be established or what action will be taken in the event of failure to achieve targets.
Membership is the key
The next question is – Will the nature and quality of decision-making be affected by who is going to be the appointing authority?
It is now common knowledge that despite the members of the Technical Advisory Committee being appointed by RBI, the monetary policy decisions taken by the RBI (i.e. the governor) in the majority of cases in the recent period were not in accordance with the majority view in the committee. There is also a commonly held view among analysts that in the run up to inflation after 2009, the RBI was behind the curve in increasing rates. There are some who hold that RBI is behind the curve now in reducing interest rates.
External members of the MPC will not be able to contribute to well-informed decisions with a medium-term rather than short-term outlook unless they have a stake in their views. For this, it is necessary that external members who have a good understanding of the economy, business cycles, inflation growth dynamics, financial sector and financial stability are appointed for a term of at least three to five years on a whole-time basis – over the economic and political cycles. Being whole-time would make them focused on the economy and financial sector and provide immediate access to the wealth of information that is available to RBI members on a continuing basis, as also the various interactions with different constituencies before the policy decision.
As long as the governor is consulted on the persons to be appointed and as along as such appointments are not distributed as largesse or for pushing only the growth agenda, it does not matter if the government is the appointing authority. After all, even today, the governor and deputy governors are appointed by the government, for a fixed term. The tenure of the external members should preferably run over political cycles. The term should be five years with a review at the end of the third year.
In a sense, the creation of central banks itself was to have a money issuing authority who was independent of the sovereign – this is the core of the issue and hence one needs independent individuals who are not driven by any conflicts of interest, who are not driven by any specific agenda, who are professional, have rich practical experience and the courage of their conviction.
The final question is on veto power. While Raghuram Rajan feels that giving a veto to the RBI governor is tantamount to having the decision taken by him and would be no different from the status quo, it seems that in the political milieu we operate in, having a veto which is exceptionally exercised and that to with a lot of explanation is required as a safeguard for ensuring the integrity of the central bank.
Usha Thorat is a former deputy governor of the Reserve Bank of India