Column: Getting monetary policy right

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Updated: August 10, 2015 11:18:39 AM

The vital thing is to have first-rate outsiders in the MPC who can establish its reputation for rigorous work

rbi monetary policyRaghuram Rajan is the first RBI Governor who can walk away to a job with higher profile. (Reuters)

India has been, through much of its 67-year history as an independent nation, a low-inflation economy. Unlike the Latin American or African states, it had never experienced hyper-inflation and even double-digit inflation was rare. I once asked IG Patel, the legendary RBI Governor and economist, why this was so. He had occupied all the top positions in the Indian economic policy-making world. He said it was the experience of inflation during and after the World War I after a century of price stability. Civil servants salaries were fixed in nominal terms at the time. They were unable then to get a Pay Commission to valourise inflationary pressures. No DA. So, they became highly inflation averse.

This stayed much the same until the oil shock of 1973. The inflation in the early 1970s unhinged politics and led to the Emergency. Once that went out of the system, inflation only occasionally threatened politics.

Then in the tenure of the UPA-II government, inflation went out of control. Or perhaps not. It may have been a planned exercise in redistributing the gains of growth towards the rural areas via inflation to alter the terms of urban-rural trade. The MSP-plus-NREGA regime pumped money into the rural areas for workers and farmers. For twenty successive quarters, the rate of inflation exceeded the rate of real GDP growth. Prices of daily purchases such as fresh vegetables and fruit were growing at double-digit rates, a rare experience until then.

Hence, the idea of inflation-targeting and an independent central bank. Perhaps, independence is too strong a word.

Autonomy in monetary policy is more the policy aim. This is uncharted territory for the Indian state. Hitherto, the bank has been subordinate to the finance ministry which appoints the Governor. Governors have usually come from within the bureaucracy, most often the ministry of finance. The present Governor, Raghuram Rajan, is an exception to this rule. He has come not only from outside the system, but from outside the country as well. This may have been the best thing Manmohan Singh did as prime minister.

Rajan has established his image as a doughty inflation-fighter. The present government has promised rapid growth, but it finds the stern interest rate stance of the Governor somewhat restrictive. On the wilder shores of the BJP , there was talk of replacing Rajan as soon as the party won power, but wiser counsel prevailed. Rajan has been cutting the interest rate only when he is convinced that inflation is on the way down.

Meanwhile, GDP growth, while a robust 7%-plus, has not been as dramatically high as the campaign of Narendra Modi seemed to promise. India is the fastest-growing economy in the G20, faster than even China, but yeh dil maange more. The policy logjam of the previous government has tied up a lot of money in stalled infrastructure projects. Corporate debt is reflected in the non-performing assets of the nationalised banks. A short-cut out of this would be a drastic cut in the interest rate. A more patient and structurally sounder route would be to undo the hardy knot of stalled projects and begin to deliver output and revenues.

Against this background, the finance ministry and RBI are engaged in enacting legislation to put inflation-targeting on a sound footing and constitute a Monetary Policy Committee (MPC). The current debate is how best to do this. As usual, the debate has got tangled with minutiae—the size (five or seven members?),  the composition of the committee (how many finance ministry appointees, how many from RBI and how many outsiders), etc, have been the subject of much speculation. Will the Governor lose his veto? Should the target rate be fixed or variable?
The UK experience is interesting here. The MPC is the only ‘independent’ part of the Bank of England. The Treasury has only one member on it. The rest are from outside except for a couple of high-level Bank staff. The government did legislate a target for inflation. But beyond that, it let the MPC get on with it. The minutes of the MPC are published with a lag with votes recorded by name. This makes the MPC transparent without becoming the subject of lurid headlines. The issue of Governor’s veto has not arisen.

The vital thing is to have first-rate outsiders—preferably, academic or market practitioners—who can establish the reputation of the committee for rigorous work. The British MPC has justified its independence by the quality of its work. It is the outcome which matters, not the rules and regulations of the structure. The Indian finance ministry tends to be bossy. But it has, in Rajan, not one of its own, but a genuine outsider. While it would be tempting for the government to demonstrate who is the boss, Raghuram Rajan is the first RBI Governor who can walk away to a job with higher profile. The loss would be India’s, in that case.

The author is a prominent economist and Labour peer

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