Monetary policy as if jobs don’t matter

The government has uploaded the draft of the proposed Indian Financial Code (IFC) for public viewing. It extends to several areas, reflected in the document’s 94 chapters. Among the issues dealt with are many that have not received much attention in the past but are becoming increasingly relevant, such as consumer protection and infrastructure. Then there is the old chestnut, monetary policy. The draft’s view of monetary policy function has been commented upon in the press, but arguably what has received most attention are the governance aspects rather than the rationale of monetary policy as specified in the Code.

The Code prescribes that decisions on the interest rate shall rest with a committee and no longer with the governor. This committee is to be constituted as follows. There will be three members from the Reserve Bank of India, including its board, and four members appointed by the government. It is believed that the balance is thus shifted towards the government, as the executive is seldom known to appoint persons who are fully independent of it.

This arrangement is tantamount to expecting the RBI to control inflation through a monetary policy committee in which it does not have a majority. Note that the bank will be statutorily expected to explain in writing when it fails to attain an inflation target set by the government. The proposed composition of the committee comes up against something akin to the principle of “no taxation without representation”. But the strangest part of the whole affair is the provision for a representative of the Centre who will participate in the deliberations without voting.

When all the other members are expected to give in writing why they have voted the way they have, the provision for an agent of the government to participate without voting amounts to surveillance. The government seriously underestimates the demoralising effect of such an arrangement, which could keep the best away from heading India’s monetary authority in the future. It must go, of course, and the majority of the RBI in the committee restored if it is to be held accountable for its actions.

The government could have avoided the credibility gap in the draft IFC had it been a little more aware of an almost three-decade-old debate among economists on the terms of independence for the central bank. In that debate, even those who bat for the primacy of the legislature in a democracy argue for the functional independence of the central bank. That is, while the central bank, as any other public body, cannot choose the goals, it must be granted functional autonomy once the goal itself has been arrived at by democratic means. Otherwise, it cannot be held accountable. This much is clear about the draft IFC’s proposals.

But there is something in the draft that has gone unquestioned in the media. This is the adoption of inflation targeting as the function of monetary policy and, ergo, the goal of the RBI.

For those unfamiliar with its history, it is not as if the RBI has not been concerned with inflation in the past, far from it. Only, it did not focus on it exclusively as required under the policy of ‘inflation targeting’. It had a wider focus, extending the radar to include output and possibly the exchange rate in addition to the inflation rate. The RBI had called this the “multiple-indicators approach”. If the draft IFC is adopted, this will be officially replaced by a focus on inflation.

While the media has made much of an alleged disagreement between the RBI and the government on such matters as public debt management, and presents some of the provisions in the IFC as further evidence of the attempt by the ministry to gain control, it has completely overlooked an area of agreement between these two bodies. This is the so-called “modern monetary policy framework” with its focus on inflation targeting on which the bank and the finance ministry are on the same page.

The agreement had actually specified a target of below 4 per cent within the range of 2-6 per cent. With respect to inflation targeting as the sole monetary policy function, far from its wings being clipped, the current leadership of the RBI has had its way.

How good is it that the RBI will henceforth focus on inflation over all other objectives, especially output growth? In my view, not so good at all. The IFC has defined inflation as the rate of change of the Consumer Price Index from year to year. Now, the largest component of this index is very likely outside the range of control of the RBI, namely, food-price inflation. The RBI cannot control agricultural prices directly through the interest rate. In fact, the only way it can do so is by managing the growth of non-agricultural output. This can lead to a lowering of the inflation rate as demand growth in the economy is lowered.

The chorus from industry leaders to lower the policy rate as inflation is currently easing does suggest that this is how it works. Moreover, there is the issue of the transmission mechanism whereby the change in the policy interest rate leads to a commensurate change in the money markets. Leading bankers in India have argued that the link is tenuous. The efficacy that is being sought to be conveyed by the use of the term “modern” monetary policy for inflation targeting is far from convincing.

It is useful to see how other economies play it. The Bank of England is a leading central bank that follows inflation targeting, but it is not widely known that it regularly fails to meet the inflation target. On the other hand, the Federal Reserve Bank of the US is not an inflation-targeting central bank. It must pursue the objectives for monetary policy established by the US Congress, namely, “employment, stable prices, and moderate long-term interest rates”. This looks closer to the multiple-indicators approach that has been followed by the RBI till quite recently. One cannot say it has not served India well. This, after all, was the RBI’s stance during the period of high growth and low inflation in India during 2003-08.

Having come so far it is perhaps only academic to enquire how the inflation target mentioned in the draft IFC is to be arrived at. There is no case in economic theory to set an absolute inflation target without reference to the state of the economy and that of the rest of the world. The Federal Reserve is spared this embarrassment as it does not have to set numerical targets by statute. Everyone understands what is meant by “maximum employment consistent with stable prices”. This is not so with “inflation targeting”.

The IFC proposes a monetary policy as if employment does not matter. Monetary policy goals should be debated in Parliament before they are adopted.

The writer teaches at Ashoka University