Monetary Policy Committee: Much Ado About Nothing?

There is no reason to believe that the government wishes to take over the primary role of the RBI.

In recent months, there has been a lot of discussion about how the Narendra Modi government is planning to gradually strip the Reserve Bank of India (RBI) of its powers. Most of the discussion points stem from the recommendations of the Financial Sector Legislative Reforms Commission (FSLRC),  headed by Justice (Retd.) B. N. Srikrishna, in 2011. The committee comprised several domain experts of law, banking  and finance, accounting and public finance.

While the terms of reference for the committee  revolved around larger financial and regulatory reforms, the recent media focus has largely centred around its impact on the RBI and its primary function of running monetary policy in India. So let us look at the latest guidelines that have been suggested by the committee.

What is the new IFC draft proposing?

There are three major changes to the monetary policy conduct suggested by the revised draft of Indian financial code (IFC), as published on the Ministry of Finance’s website on 23 July (point 256).

• The primary objective of the RBI is achieving price stability, in conjunction to maintaining a sustainable level of growth as per the central government.
• The new mandate of the central bank will be to target consumer price index (CPI) or retail inflation for each financial year, which will be determined by the central government in consultation with the RBI every three years.
• The monetary policy stance will be determined by a seven-member monetary policy committee (MPC).  The IFC proposes that the MPC will comprise three members from the RBI (including the governor) and four members appointed by the central government, subject to certain criteria. The MPC will also have a non-voting representative of the central government, and a secretary to the MPC, who would record the discussions and votes in the interest of transparency.

While the guidelines are broadly in line with the functioning of any major international central bank and a robust monetary framework, there are three questions we need to ponder over, before deciding whether such new rules are required.

• First, is the RBI ok with an inflation targeting framework?
• Second, is the RBI comfortable with a MPC taking a decision on monetary policy, rather than the governor alone? Can the government appoint people with questionable integrity to the MPC in order to influence monetary policy?
• Third, is there a risk that the government will dilute the inflation mandate by setting high inflation targets, in order to influence the stance of monetary policy?

What does the RBI want?

It is rather interesting that the all major changes as suggested by the IFC are similar to the suggestions made by the Dr. Urjit Patel committee report, which was released in early 2014, and has been somewhat instrumental in driving India’s monetary policy since then.  Consider the main recommendations of the Patel committee:

• RBI should adopt price stability as its main goal, under a flexible inflation targeting (FIT) approach. The price target should ideally be set at 4% with a + 2% band.
• RBI policy should be set by a five-member MPC, with three internal RBI members (including the governor)  and two external members who would be appointed by the RBI governor and deputy governor, who will function as chairperson and vice-chairperson of the MPC.

So, the  recommendations of the IFC and the Patel committee are similar about the institutional contours of monetary policy conduct in India. In fact, the government has already signed an agreement with the RBI, approving the FIT framework for RBI’s primary objective, with a 4% target, and a + 2% band. This would rule out the first and the third problems that the RBI may have, as the government agrees with its suggested inflation path and framework to achieve it.

So what is the issue?

The primary source of confusion/confrontation seems to be about the composition of the MPC. While RBI’s own committee has recommended that a majority of the members be from the RBI, the draft IFC recommends giving external members a majority. This problem is not unsolvable. Globally, there are examples of both models being in practice. For a large number of central banks which have an MPC, they tend to have external members, who may or may not be in majority.

For instance, the Bank of Japan and Bank of Thailand have a larger number of external members on their MPC, but their credibility remains steadfast, as far as the market impact is concerned. Similarly, in the case of the Philippines, the finance minister equivalent actually sits on the monetary board which decides monetary policy, but that does not prevent governor Amando Tetangco from speaking his mind and the central bank from operating independently.

What matters more is appointing credible and knowledgeable people—internal or external—to the MPC and letting them operate independently. After all, the governors and deputy governors in the RBI and all other central banks are appointed by the government. More so, both the Patel committee report and the draft IFC have given strict guidelines on how the external members can be appointed, and what rules and pre-conditions would need to be met before their selection. As long as one believes that a particular government is not trying to run down institutions, this author does not see risks of any compromises being made in the selection of external MPC members.

Further, the larger issue remains whether RBI is currently setting policy under any duress, and the answer is no. Governor Raghuram Rajan’s policy steps so far have worked in lowering inflation expectations, and his stance shifted appropriately towards supporting growth as inflation declined. Even he has said previously that setting up an MPC is not the most urgent priority, and that bringing down inflation in a sustained manner is.

What are the forward steps?

A MPC does need to be set up in the future, to ensure continuity of thought and decision making in the wider aspect of monetary policy. But this can wait until the RBI and government agree on its framework through dialogue and deliberation, and what the composition should be so that it will not affect RBI’s credibility, followed by its independence. This is important, as even an independent body may not necessarily be credible, hence I would emphasise more on building credibility of actions, rather than focusing only on independence.

After all, monetary policy cannot be set in isolation to what is happening on the fiscal and regulatory side of the government, particularly in low income economies such as India. I actually agree with the Patel committee recommendations of having more internal members than external members in the MPC. But I do not see the presence of external members as a sign that the government wishes to take over the primary role of the RBI, which is to lower inflation through monetary policy.