MAVERICK VIEW. Monetary policy: new rules, new actors

February 20, 2015, is a watershed in the relations between the Reserve Bank of India and the Centre. For the first time an agreement has been formally signed by the RBI and the government, setting out the primary objective of monetary policy of maintaining price stability while keeping in mind the objective of growth.

Under the agreement, the RBI will aim to bring inflation below 6 per cent by January 2016, and for the financial year 2016-17 and all subsequent years, the target shall be 4 per cent with a band of plus or minus 2 per cent (according to clause 2 of the agreement).

The RBI shall be seen to have failed to meet the target if inflation is (i) more than 6 per cent for three consecutive quarters for the financial year 2015-16 and all subsequent years, and (ii) less than 2 per cent for three consecutive quarters in 2016-17 and all subsequent years (according to clause 6 of the agreement). There appears to be asymmetry between the upper bound and the lower bound for inflation. Moreover, there appears to be inconsistency between the target (in clause 2) and the determination of the failure (in clause 6).

If this asymmetry is a conscious decision it has far-reaching implications for the operation of monetary policy in 2015-16. Given that the year-on-year inflation rate as of February 2015 is 5.3 per cent, prudent management would warrant that the RBI rule out, in the first half of 2015-16, any relaxation of policy interest rates and ancillary policy measures.

Under clause 4 of the agreement it will be incumbent on the RBI to publish the operating target(s) and establish an operating procedure through which the operating target will be achieved; any change in the operating target in response to evolving macro-financial conditions shall also be published. It is not clear whether there would be provision for a force majeure in the case of, say, a war, a natural disaster or pestilence.

In case force majeure is to be cited it does not appear to be appropriate to alter the targets through the operating procedure, but there should be an amendment to the agreement signed by the government and the RBI. It is hoped that the monetary policy review of April 7, 2015, would be used to publish the operating procedure.

A vital element in the new monetary policy order is the setting up of a monetary policy committee (MPC). There are sharp differences between the FSLRC and the Urjit Patel Committee on the constitution of the MPC. This issue has been discussed in extensio in earlier columns.

The agreement is notably silent on the setting up of the MPC. The FSLRC recommends an eight-member committee of which only two would be RBI executives and the government would appoint five external members.

Further, there would be a non-voting executive of the government. In contrast, the Urjit Patel Committee recommends a five-member committee of whom three would be RBI executives and two would be external members. The FSLRC model for the composition of the MPC is contrary to the set-up in all the major countries; there is probably no country in which the external members outnumber the executive members.

The FSLRC recommendation is insidious in that it is a blatant attempt to make things awkward for the RBI by holding it accountable for the decisions of the external members. If the RBI is to be accountable it should have a majority of executives on the MPC.

The FSLRC proposal has a proviso for a veto for the governor. If there is such a veto it would be best to continue with the present technical advisory committee. It would be meaningful to have no veto for the governor but in that case the Urjit Patel Committee model should be followed while setting up the MPC. Having a government executive on the MPC, albeit without voting rights, would go against the spirit of an MPC. Big Brother may not have voting rights but can have an overbearing dominance over the working of an institution.

A match referee cannot also be the third umpire, the umpire on the field, a player and also a spectator. Such a ridiculous proposal goes against the grain of the present government’s fundamental philosophy of maximum governance with minimum government. Hence, the FSLRC recommendation on the composition of the MPC should simply be tossed out.

The amendments to the Finance Bill 2015 set out in paragraphs 154-157 imply that the money market regulatory powers would be taken away from the RBI. Such an important measure has not earned any mention in the Budget speech. The government has been quick to reassure that the RBI’s powers in the money market would not be taken away and that the provisions in the Finance Bill 2015 would be amended. This leaves one with the uncomfortable feeling that goblins have surreptitiously introduced fundamental changes in financial legislation. The government would do well to deactivate the goblins.