Reserve Bank Governor Raghuram Rajan surprised markets again by raising interest rates. The surprise is heightened by the RBI’s earlier observation that it would closely monitor economic development and inflation trends. This is in sharp contrast to policy announcements in advanced countries where forward guidance is offered on a medium to long term basis. How then did RBI make such a move?

The RBI’s tough stance, along with uncertainty in the policy environment and the apprehensions over US tapering, are showing up in the ever-declining growth in the industrial and services sector. The index of industrial production (IIP) for November 2013 continued its dismal downward journey. The key contributors to the slowdown continue to be consumer durables, including automobiles, gems and jewellery and home appliances.

Central bank role Growth has been hit for two reasons — first, borrowing has become costly for the productive agents and second, it has stifled demand for consumer durables. High interest rates have choked not inflation, but manufacturing and growth.

In fact, market anecdotes tell us that every sector other than pharmaceuticals has suffered because of the slowdown arising out of high interest rates and uncertainty in policy, .

A pertinent issue in monetary policy, particularly with elections around the corner, is the issue of accountability and responsibility for fixing interest rates. Charles Goodhart, a member of England’s Monetary Policy Committee between 1997 and 2000, has observed that central banks must manage liquidity in the interest of systemic stability.

But Goodhart also wondered as to why the central bank, a non-elected body, should set the official interest rate. Goodhart believes that central bankers do not take enough cognisance of financial conditions while fixing interest rates.

After the Great Depression of 1930s, in many countries, including the UK, official interest rates were fixed by the government, with a few exceptions like the US, Germany and Switzerland. It was only sometime in mid-nineties that central banks assumed the responsibility of fixing interest rates.

This came about after Paul Volcker, Federal Reserve Chairman during the 1980s, had conquered the demon of inflation in the US; concepts like central bank independence thereafter became popular. Inflation targeting assumed significance in a number of countries. Even so, in the UK — as also in many other countries — not one individual, but a committee, under the aegis of the central bank is assigned the role of setting the interest rates. Its members are held accountable for their inputs.

Many objectives If the central bank is assigned the responsibility of targeting inflation, it follows that the effective instrument is interest rates. But during the present situation, the central bank has also to pursue multiple objectives of growth, employment, financial stability, and expectations management through an efficient communications policy.

In India, the Governor is exclusively responsible for fixing the repo rate, unlike in many other countries. The role of the technical committee is mainly advisory, and members are not accountable for their inputs.

Neither is the highly competent, well trained and professional staff of the RBI held to account. Governors, present and past, during this difficult economic phase, have attempted to articulate a rationale for RBI’s policy steps — correct or incorrect. But neither was inflation tamed nor growth re-ignited. Is anyone answerable?

There is a need to think out of box on setting interest rates. It can be argued that the RBI has substantial information about the market and therefore, it is best that interest rates be set by it.

That said, some caveats need to be considered. First, there is a lack of transparency in RBI’s interest rate decisions, especially in the absence of a separate debt management office. The market perceives that the RBI is making effort to facilitate government borrowings at lower than market rates.

This is not to make a case for ‘autonomy of central banks’, but to argue quite the opposite: That a central bank setting rates in isolation, more so in an emerging economy in economic crisis, raises questions of accountability to the people. In the present situation, the RBI simultaneously operates both at the short and long end of the market.

Second, the RBI’s approach, focused on fire-fighting inflation, which is now driven by supply side constraints, is at variance with that of the market, which seeks growth. In difficult times, and in underdeveloped financial markets, governments have played a vital role in fixing interest rates.

It is now well recognised that the sins committed by central bankers in the last two decades led to the global recession. Therefore, arguments in favour of independence seem very unconvincing.

In India, the Ministry of Finance and the RBI could jointly be made responsible for setting interest rates. That could build the confidence of markets, analysts and investors.

(The writer is RBI Chair Professor, IIM-Bangalore)

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