At a symposium in Switzerland in May this year, Reserve Bank of India (RBI) Governor >Raghuram Rajan told his audience, “The government can fire me, but the government doesn’t set the monetary policy … ultimately the interest rate that is set is set by me.”
All indications are that the position is set to change. Setting the interest rate will soon cease to be the prerogative of the RBI Governor. It’s hard to resist the feeling that the RBI’s actions over the past year will have contributed to the changes that are imminent.
In the present scheme of things, the RBI Governor consults his four Deputy Governors. There is a Technical Advisory Committee on Monetary Policy with five external members that provides advice. The Governor listens to bank chiefs and economists. But the final call on interest rates is that of the Governor alone.
In the past, RBI Governors did not think it necessary to trumpet the fact. They thought it more politic to emphasise that decisions on interest rates were made after due consultation with the government.
RBI autonomy Discretion is warranted because the RBI’s autonomy is not sanctioned by statute. The RBI can only be as autonomous as the government wants it to be. Over the years, as the RBI established a track record of performance, governments have found it sensible to confer a large degree of autonomy on the RBI. Governors, in turn, have understood that having the political authority on board, to the extent possible, was crucial.
This informal arrangement is poised to end soon. The government wants to put in place a formal mechanism that will circumscribe the RBI’s role in monetary policy. Sections of the political class and the bureaucracy were never too happy with the autonomy the RBI has enjoyed. Their hands may well have been strengthened by the RBI’s actions over the past year. In particular, the RBI’s attempt to insulate inflation targeting from government influence and its zeal for inflation targeting itself appear to have backfired.
In March 2013, the Financial Sector Legislative Reforms Commission (FSLRC) headed by Justice B.N. Srikrishna proposed the creation of a Monetary Policy Committee (MPC) for deciding monetary policy. The MPC would comprise the Governor, one Deputy Governor and five external members appointed by the government, of whom two would be appointed in consultation with the RBI Governor. One representative of the government would be present but would have no voting rights. The United Progressive Alliance (UPA) government did not act on this proposal. It was, perhaps, best countered through a quiet dialogue with the government.
Targeting inflation Instead, in January 2014, the RBI came up with the report of a committee headed by Deputy Governor Urjit Patel. The committee proposed an MPC with three internal members (the RBI Governor and the Deputy Governor and executive director in charge of monetary policy) and two full-time external members who would be appointed by the RBI.
Like the global war on terror, the RBI’s targeting a CPI inflation rate of 6 per cent threatens to turn into a never-ending pursuit of an ever-moving adversary
The Patel committee contended that inflation targeting should be the primary objective of the RBI, that is, the RBI should have a clearly-defined number for inflation that monetary policy must target. It then proceeded to spell out the inflation targets: consumer price index (CPI) inflation of 8 per cent for January 2015, 6 per cent for January 2016 and thereafter a target of 4 per cent with a band of plus or minus 2 per cent.
The intention was clear. Not only would the RBI set an inflation target on its own, the MPC that would be mandated to achieve the target would be constituted entirely by the RBI. The government would have no role in the matter. To have expected any government to accept these proposals required more than ordinary naivete.
In the period since, the RBI has gone on to act on the Patel committee’s inflation targets with a zeal that many in the business community must find disquieting (although few are willing to say so). At a conference in Mumbai last month, industrialist Y.K. Modi told the RBI Governor that he needed to reduce the interest rate by at least 200 basis points. There was a ripple of laughter in the room. One was not sure whether it was because the members of the business world found the suggestion unreasonable or because they thought it had no chance of being accepted.
The RBI has kept the repo rate unchanged at 8 per cent since January 2014. CPI inflation has declined in recent weeks to below 8 per cent, which is the RBI’s target for January 2015. The RBI, however, refuses to consider a rate cut until it is convinced that it will meet its target of 6 per cent for January 2016.
This could prove a tall order. Oil prices have tumbled because global economic growth has been poor. However, supply shocks, such as disruptions in the Middle East or in Ukraine, could quickly reverse the fall. Foreign funds have exited markets in emerging markets including India on expectations of a rate hike in the U.S. This has caused the rupee to depreciate which, in turn, gives an upward push to inflation.
A significant part of inflation in India is structural in character and it arises from shortages of supply. Food inflation is an ever-present threat given that nearly 50 per cent of the weight in the CPI is accounted for by food items. As wages rise with economic growth, a rise in the inflation rate is to be expected. Growing financial inclusion, which results in greater monetisation of the economy, also tends to fuel inflation.
For these reasons, the Economic Survey of 2010-11 had judged that wholesale price inflation of around 5 per cent was inescapable. This would translate into CPI inflation of 7-8 per cent. Like the global war on terror, the RBI’s targeting a CPI inflation rate of 6 per cent threatens to turn into a never-ending pursuit of an ever-moving adversary.
Rate cut Not lowering interest rates risks derailing the incipient recovery in the Indian economy. We need a revival in investment to ensure an early return to a growth rate of over 7 per cent. The RBI Governor has argued that a cut in interest rates will not make much of a difference to investment because it does not reduce the cost of funds significantly. This is true but an interest rate cut could still provide a stimulus to the economy.
A rate cut would lead to an increase in the value of government bonds held by banks. This would enhance bank capital and make banks more willing to lend. It would boost cash flows at highly indebted companies and enable them to access both loans and equity. Thus, a rate cut could stimulate both the demand for credit and the supply of credit.
Market rates already show signs of softening. Several banks have cut deposit rates in recent weeks. The RBI annual report (2012-13) shows that the weighted average lending rate on fresh loans has been trending down since September 2013. In keeping policy rates fixed, the RBI risks falling behind the curve.
The new government has thus far been circumspect in its dealings with an RBI Governor of international stature. However, it was unrealistic to have expected a government keen to revive the economy not to react to the RBI’s initiatives on monetary policy.
The reaction has not been long in coming. The government is said to be planning an eight-member MPC dominated by five external members, as proposed by the FSLRC. The concession is that the RBI Governor will have a say in the selection of all external members along with the government and one outside expert. The inflation target will be set by the government or require its endorsement. These measures will amount to a dilution of the autonomy the RBI has had in formulating monetary policy. They may also limit the flexibility the RBI has to respond to external shocks.
In an economy such as ours, it is entirely legitimate for the political authority to want a say on inflation and interest rates as these impact the lives of people more critically than in a high-income economy. Through a process of consultation and persuasion, RBI governors had managed to keep the government on their side even while exercising substantial autonomy. Any attempt to change the situation to the advantage of the RBI was bound to invite a response from the government. Sure enough, Empire has struck back.
(T.T. Ram Mohan is professor at IIM Ahmedabad.)
