Mint Street Vs North Block: The Problem Is Built Into The Very Design of The MPC

The government has only itself to blame if, after kissing goodbye to Raghuram Rajan, it finds his successor Urjit Patel equally resistant to taking its concerns on board while deciding monetary policy.

It would be too early to predict another frost in the relationship between the Reserve Bank of India (RBI), which unexpectedly held rates yesterday (7 June) despite having no reason to, and the Finance Ministry, which thought it had found a more sympathetic ear in the Monetary Policy Committee (MPC), where it has three nominees in a six-member panel.

But the MPC is no poodle, and is moreover keen to display its independence, if needed by doing the wrong thing at the wrong time. This is what it accomplished in its latest monetary policy when it held rates despite a benign (and possibly falling) inflation scenario, a reasonable fiscal stance, and weak gross domestic product (GDP) growth in a post-demonetisation world marked by overleveraged balance-sheets and excess bad debts with banks.

Little wonder Mint Street and North Block were at daggers drawn yesterday. While Governor Patel emphasised that “all the MPC declined the request of the Finance Ministry for a meeting (ahead of the monetary policy)”, Chief Economic Adviser Arvind Subramanian criticised the policy in no uncertain terms. “Seldom”, he said, “have economic conditions and the outlook warranted substantial monetary policy easing”, and went on to point out that the RBI’s inflation forecasts have not been able to hit the broad side of the barn. “Inflation forecast errors have been large and systematically one-sided in overstating inflation.”

Verbal fisticuffs between those who make monetary policy and those who have a larger public mandate to run the economy sensibly are not new; but the problem this time has been compounded by two things.

One is the MPC’s need to assert independence, especially after the exit of loquacious Raghuram Rajan and his replacement with tongue-tied Urjit Patel as RBI Governor. Doubts about whether Patel can stand up to the Finance Ministry arose when the RBI was seen to playing second fiddle to the ministry, when high-value notes were demonetised last November. To assert independence, the Patel-led MPC prematurely shifted to a “neutral” stance on monetary policy this February, implying that there would be no further cuts. But data since then has warranted a shift in stance, but the RBI is too embarrassed to change course suddenly.

The second reason for the current tension between Mint Street and North Block is the structure of the MPC itself. It is designed to give the RBI the upper hand, and the Finance Ministry did not help matters by choosing “independent” experts, who were not primed to take their own viewpoints to MPC meetings. When the ministry ham-handedly tried to ask MPC members to meet it before the policy meeting, the members rightly bristled and declined.

Earlier, RBI governors happily trotted off to North Block to listen to what the finance minister and the finance secretary had to say, even though they took their own calls on rates based on their best judgment of the situation. But trying to do the same with six members is clearly not possible.

The MPC was created for three reasons. One is the theoretical proposition that six heads are better than one, with the MPC modelled on the committee way of deciding US Fed policies. The second related reason was to shift power from one unaccountable individual (the Governor) to a more accountable committee. The third reason was to give the Finance Ministry a chance to be heard through its three nominees on the MPC.

None of these reasons actually hold.

For one, the MPC’s decision-making structure is heavily loaded in favour of the RBI. Reason: the RBI’s three members represent an institution, where two of the members report to the third member, the RBI Governor. In short, one can expect the RBI part of the MPC to act in unison, while the “independent” experts nominated by the Finance Ministry may go off at a tangent. In any case, even if there is a tie in voting, the Governor can over-rule the rest.

Two, the MPC structure, far from making the Governor less powerful, makes him more powerful, and less accountable. Earlier, when RBI governors goofed, they could be criticised and pilloried. Consider how Duvvuri Subbarao was repeatedly castigated by the markets for his “babysteps” and staying behind the curve on rate increases when inflation was out of control during UPA-2. Now, with an MPC structure dominated by him and his institution, any wrong decision will rest with the committee as a group, and not just the Governor. The RBI Governor now has more power with less accountability for his actions on monetary policy.

Three, the Finance Ministry goofed by not picking its nominees to the MPC based on its own ideology. It seems to have fallen into the trap of seeking independent voices, who, in their exercise of this very independence, are effectively not representative of the fiscal side’s concerns. This mistake has to be rectified if the fiscal side is to be heard at MPC meetings, even when one can accept that the RBI must get the upper hand in decisions. Now it gets the upper hand and the Finance Ministry gets very little voice.

Finance Minister Arun Jaitley can make amends by talking to his three MPC nominees, one-on-one, well before the next MPC meeting in early August. At the last meeting, only one of them – Ravindra Dholakia of IIM – took a line different from the majority. Two others, Chetan Ghate of ISI, and Pami Dua of the Delhi School of Economics, toed the RBI line.

Another possibility is to reduce the MPC to five members, with three coming from the RBI, and the other two being clearly Finance Ministry nominees who can take up the ministry’s views. In this scenario, the RBI will still be boss of monetary policy, but the charade of the Finance Ministry nominating independent members who do not represent its views will end.

The MPC structure as it now stands is inappropriate for India. It needs changing.