Whose monetary policy?

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SummaryIt should be left to an independent central bank with a clear brief and instruments

It should be left to an independent central bank with a clear brief and instruments

Indian monetary policy law, like that of many advanced and most emerging economies, needs to define the objectives of monetary policy. The sudden shift away from inflation and growth to a defence of

the rupee has caused a lot of confusion. In addition, the law needs to lay down the instruments of monetary policy. This could be the repo rate or any other chosen rate. Once this is done, the RBI needs to be made accountable and given independence in order to achieve these objectives.

Today, even if the government achieves Rs 60 to the US dollar, the cost of defending the rupee is too high. Beyond the tangle that the RBI is now in, these events point to the larger question of monetary policymaking in India. Decisionmaking on monetary policy in India will become increasingly difficult in the next two years. The US Fed will stop easing and US interest rates will rise. If the RBI leaves interest rates in India unchanged, Indian assets will become relatively unattractive. This will put pressure on the rupee to depreciate. If the RBI increases interest rates to prevent this from happening, growth in India will suffer. If it lowers rates, there could be additional pressure on the rupee. There may be episodes of high exchange-rate volatility, such as when the Fed announces the date of reducing its purchase of treasury bills, buys less bonds, stops them altogether, or when it starts reducing the size of its balance sheet.

It is well understood by now that once the capital account is open, a country has to choose between pegging the exchange rate and pursuing an independent monetary policy. The impossible trinity tells us that with an open capital account you cannot have both a pegged exchange rate and monetary policy independence. If the business cycles of the Indian economy were perfectly aligned with those of the US, there would be no problem. But if the US is going to raise rates, we have to make a choice: let the rupee be flexible or peg the rupee to the dollar and tighten along with the US. The middle paths that we try to follow are fundamentally problematic and may only have some limited, short-term impact. Meddling with the exchange rate can only be done by distorting monetary policy, and anyone who says

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