RBI governor, Duvvuri Subbarao, has made two interesting speeches in the space of 5 days, which shed significant light on his personal thinking on RBI?s role. One, of course, can?t be sure if the entire bureaucracy of RBI thinks the same way. In a speech on July 31st (parts of which were excerpted in FE Reflect on Wednesday), the governor made clear that he believed RBI had to keep its remit beyond the narrow focus of inflation targeting?price stability had to be combined with output stability and financial stability. This sounds closer to the US style of central banking than the European and UK style of inflation-focused central banking. There seems to be much merit in Subbarao?s thinking on this matter. At our level of development, central banks need to think about growth. In addition, as he pointed out in the same speech, it is far from obvious which measure of inflation RBI should target in any case. Also, inflation in India isn?t always a demand side phenomenon, supply crunch-led food inflation being a case in point. In such circumstances RBI can only play a negligible role in managing some kinds of inflation. On the other hand, RBI can and should do demand management through interest rates?one only wishes that the governor?s thinking translated into concrete action straightaway, through a more accommodative monetary policy. RBI worries about excessive government debt, but unless it loosens interest rates, government expenditure will have to make up for the fall in private expenditure in a downturn?that may have worked out in 2008-09, but it?s not sustainable. Of course, Subbarao correctly pointed out the lethargic monetary policy transmission mechanism in India, which reduces the efficacy of monetary policy.
The answer to that is financial sector reform something one thought was on the backburner what with the financial crisis. But the governor chose to put this back on the agenda in his second speech on Wednesday. Subbarao chose to use the ?recalibrate? word to describe the way forward for financial reform, but the fact that he still intends to proceed with reform is a welcome sign. The transmission mechanism needs a well functioning bond market, which should be a top priority for RBI. In addition, currency and derivative markets also need to be developed. It still isn?t clear what exactly RBI intends to do about full capital account convertibility and permitting more derivative instruments, but the hint about recalibration seems to suggest that these will likely happen once we are out of the woods. RBI is, however, unlikely to shed its conservatism about bank regulation in a hurry, but given the freshness of the crisis, it may have more time to think about reform in banking than it has to get monetary policy right.
