We observe, once again, a discord between the Ministry of Finance and the Reserve Bank of India (RBI) on priorities between growth and inflation targeting for the economy. Evidently, the projected fall in GDP growth to a low of 5- to 6 per cent has alerted the government set to face parliamentary elections next year. As for the RBI, it chose to continue with its tightening of credit, in a bid to target inflation.
The central bank is often viewed as independent of political pressures from the elected bodies. Autonomy in this context permits policy space to the bank which usually pursues price stability as its main policy goal.
The notion of central bank autonomy vis-a-vis the fiscal authorities over monetary policy, as relates to the current impasse in India, does not, however, capture the failed autonomy of monetary policy which is experienced by open economies. Thus, with free flows of overseas capital, the central bank’s responsibility to manage the exchange rate (at a fixed rate or within an acceptable range) makes it intervene in the foreign currency market, with purchases or sales to stabilise the exchange rate. This adds or depletes the stock of official reserves held, which, as reserve money, provides the source for changes in credit flows in circulation. To resist the changes in prices which, as per conventional theory, is believed to result, the central bank gears the direction of its monetary policy.
Sequences as above are identified as one of a ‘trilemma’ with an “impossible trinity” of achieving full capital mobility, a managed exchange rate and autonomy in monetary policy. While the revocation of capital controls remains unacceptable monetary policy often has to adjust to the changing circumstances which destabilise prices. Thus, monetary policy can no longer remain autonomous in an open economy. Thus, actions to prevent an appreciation of domestic currency by purchases of foreign currency would add to official reserves with related expansions in money supply which is likely to drive monetary authorities to target inflation as their sole concern. The sequence is likely to be in reverse gear when capital flows are at a low ebb and the currency tends to depreciate. Situations as above do not qualify as national autonomy in monetary policy. Continuing with official reserves, maintaining those has its own priority for developing countries, since they do not enjoy the status of ‘key currencies’ in global economy. Maintaining free (and often volatile) flows of overseas capital along with a managed exchange rate thus adds a fourth dimension to the ‘trilemma’ faced by monetary authorities, described in the literature as ‘quadrilemma’. For India, the track record of monetary policy in recent years indicates a total denial of autonomy, with inflation targeting over-riding other concerns.
Over the last two years, the call rate has been pitched over 8 per cent and the lending rate set even higher, between 10.50 per cent and 10.75 per cent. The RBI justifies its current stance to continue with the high rates on grounds of inflation, notwithstanding what it observes as the current downslides in the aggregate growth rate of the economy at 6.5 per cent and of industry at 2.6 per cent, with further downslides projected for next year. However, the position on the matter, as taken by the RBI, which ostensibly relies on the principles of central bank autonomy, does not carry much weight. This can be verified from what we observe above regarding the turns in its policy which were largely conditioned by the second-round effects of capital flows in an open economy.
Can govt. “walk alone”?
If the RBI has declined to share concerns about growth, , can the responsibility be shouldered by the elected government alone? Looking more closely at the government’s strategy , especially with the proposed budgetary consolidation, it does not seem likely. The recent launch of the fiscal consolidation plan hints at major distributional shifts which include cut in subsidies for food, fuel and related items. To fill in gaps in the fiscal budget, increased borrowings from the market would be needed, which will also raise the share of interest payments in public expenditure, and often at the cost of cuts in social sector expenditure as well as capital investments. All the above belie the finance ministry’s optimism that fiscal consolidation will help ‘investor confidence’ and thus a “path of high investment, higher growth, lower inflation and long-term sustainability”.
Continuing with unquestioned faith on the part of the RBI on central bank autonomy, which is illusory; and of the Central Government on austerity and fiscal discipline as a panacea for growth (leave alone distribution) can no longer be trusted as a solution for a revival of the ailing economy.
The author is a former Professor of the Centre for Economic Studies and Planning, Jawaharlal Nehru University.