A monetary policy for and by the people

“When we speak about monetary policy, it is interference in the independence of the central bank, when he (Rajan) speaks about fiscal policy, its fine”.

This is an extract from a news report from one of India’s business dailies quoting an unnamed senior official in the finance ministry. The story may or may not be true, or, for that matter, the official in question may or may not be senior enough to warrant a perception that it represents the official view of the government.

But it nevertheless serves to highlight a larger issue, namely, the nature of interconnectedness between the monetary and fiscal policies of a national economy, and the case for autonomy in the functioning of the monetary authority of a national economy. More specifically in the Indian context, the question revolves around the role and the respective domains of the finance ministry and the Reserve Bank of India (RBI).

Should the monetary policy of the RBI be accommodative of the concerns of the finance ministry on growth and distribution of national income, however flawed that such a recommendation may be, in the former’s opinion? Every finance minister and senior officials in the ministry would like to believe that they have a clear idea of the contours of a monetary policy that, while ensuring price stability, would also deliver for the economy a level of output that makes the size of fiscal deficit look more palatable to the investment community.

Unfortunately, those views do not always find resonance in the mind of the occupant of the corner suite at the Shahid Bhagat Singh Marg office of the RBI, to wit, the governor! There is a chorus of protest from the policy community saying that any suggestion from the government on interest rates or liquidity in the system smacks of an attempt to undermine the autonomy of the RBI, with potentially adverse consequences for capital flight. Expectedly, this is soon followed by ritualistic obeisance on the part of officials of the finance ministry to the notion of supremacy of the RBI in fashioning the monetary policy. The controversy is put to rest, at least for the time being.

But such assertions notwithstanding, it must be said that the relationship between the finance ministry and the RBI over policy formulation is beset by strain. The RBI, too, does its bit to keep the tension simmering by weighing in with observations on the Centre’s conduct of fiscal policy, from time to time.

A recent case in point is that of the speech delivered by Governor Raghuram Rajan at the CD Deshmukh memorial lecture last month. He said, “Deviating from the fiscal consolidation path could push up government bond yields, both because of the greater volume of bonds to be financed and because of the potential loss of government credibility on future consolidation.”

Is it possible to argue that the RBI should have a say in the formulation of the nation’s fiscal policy while simultaneously preserving its exclusive role in the crafting of the monetary policy? Can we take the quote attributed to a senior official in the finance ministry mentioned at the beginning of this article and (stripping it of sarcasm) take it as a sincere articulation of where the RBI stands on the formulation of macro policies for growth and price stability in the economy?

In order to do so, it is necessary to start from the first principles. What are the policy objectives of an emerging economy such as India? Clearly, it is to ensure a certain rate of growth in output/incomes that over time will lift still vast sections of the population from a degrading state of deprivation concerning the most basic needs of food, clothing and shelter. It can be nobody’s case that such growth can be achieved in the face of rampant inflation. So there must be growth, and at the same time the economy should operate with a modicum of price stability.

That sets the stage for delineating the roles of both the government of elected representatives of the people and the technical arm of the government in the form of the RBI. The possibilities are: Both these entities are collectively responsible for growth and price stability; the government will be exclusively responsible for achieving economic growth while the RBI is tasked with ensuring that prices remain stable or, at worst, rise within a moderate range; a third possibility is that the RBI should be responsible for both growth and price stability and the government merely takes care of the distributional aspects through income/wealth taxation.

But such a narrow, technocratic view of executive authority is out of sync with the democratic structure of India’s body politic. Certainly no one in India would argue for a sharply restricted role for the elected representatives of the people. We are thus left with only the first two of the three options. In the first case — joint responsibility — it is difficult to see how the government’s perspectives on monetary policy in so far as they have a bearing on what the monetary authority is expected to do either with regard to promoting growth or stable prices in the economy, could be ignored in the name of preserving the central bank’s autonomy.

In the second case, where the monetary authority takes care of price stability while economic growth is managed by the government, we have to reconcile the division of responsibility with the initial construct: that while the monetary authority should be left to manage the price situation without any interference from the government, it should also be granted the freedom to weigh in with its comments and suggestions to the government on how the fiscal affairs ought to be managed.

However, that would be reasonable only if we accept that while fiscal policy can affect both growth and price levels in the economy (hence the freedom to the RBI to tell the government what it should do), monetary policy can only influence prices in the economy. Stated differently, things such as ‘repo’ rate, limits on commercial banks’ access to reserve funds, and such other tools of monetary policy do nothing to change the output levels in the economy.

The question is whether the proponents of RBI autonomy are prepared to accept such a narrow view of what it or for that matter, any monetary authority, can achieve with the policy options available to them. Mind you, recent experiences in Japan and the European Union suggest that efforts at boosting growth through monetary policies have run into rough weather if not quite hitting a brick wall of resistance.

Even in the US, which has seen unprecedented levels of monetary tools being deployed to pump prime the economy over extended periods of time, questions are being raised about the quality of growth that such policy options have engendered.

So the moral is this. The RBI has to make its stance clear as to whether its policy tools impact growth or not. If it is the former, then it must take the government on board with regard to its own plans. Alternatively, it must concede to the rest of the world that the policy tools are effective only for price stability and that too, only when they are in accord with its own vision on fiscal policy, imposing, in the process, a situation of policy forbearance on the part of the government. It can’t be both.