How The MPC Has Made RBI Governor Urjit Patel’s Job Trickier And Harder

The constitution of the Monetary Policy Committee (MPC) with the appointment of three government nominees will change the institutional structure for rate setting but not the essence. With three members from the Reserve Bank of India (RBI) and three from the government, the latter now gets a direct voice in policy making. But with the Governor getting a casting vote in case of a deadlock, the policy will usually bear the fingerprints of the RBI Governor.

However, the job of the RBI Governor has just gotten harder and trickier. The new Governor, Urjit Patel, will have to be a consensus builder and a good manager of ties with the finance ministry. The success or failure of the MPC experiment – we can’t call it anything but an experiment right now – depends on how Patel shapes the MPC’s early days.

The reason why Patel will have to tread carefully in the beginning is because the MPC will have to establish its autonomy in order to send the message that it is not going to be unduly influenced by the finance ministry’s obsessions over interest rates. In the initial phase, the market will assume that the three members nominated by the government will hunt in packs and vote for rate cuts.  The market will also presume that these three nominees will be given directives by Finance Minister Arun Jaitley on how to vote.

It will be upto Patel to convince the government not to do so, and also encourage its nominees to assert their own independence by participating robustly in discussions on rates.

The worst thing that can happen is if the three RBI nominees (Patel, Deputy Governor R Gandhi and Executive Director Michael Patra) vote together and the other three vote differently. The MPC will establish its autonomy only when it is clear that all the six members of the MPC can vote differently based on their own independent understanding of what interest rate makes most sense in the latest context of inflation and growth.

In theory, the MPC is an improvement over the current system where the Governor decides monetary policy after listening to the Technical Advisory Committee (TAC). The implicit assumption is that six heads are better than one. But unless you want to believe that the conduct of monetary policy under Duvvuri Subbarao and Raghuram Rajan was bad because the Governor used his own judgment and veto, it is not apparent that a multi-member MPC is inherently better than a one-man band headed by the Governor. Reason: Governors do not decide monetary policy in a vacuum. They get inputs both from their own internal policy wonks and from the TAC. Even though both Subbarao and Rajan took decisions that were at variance with the TAC majority, the fact is that concentrating power in the hands of the Governor helped establish the RBI’s autonomy with a degree of clarity that an MPC will not initially have.

The working of MPCs in the US, Europe and the UK does not prove that many heads are better than one. Monetary policy, despite its initial utility after the Lehman crisis, has been called into question repeatedly by bankers and economists, especially since near-zero or negative interest rates have damaged banks and introduced perverse incentives for the asset markets without necessarily getting western economies out of a ditch.

The truth is autonomy by itself does not guarantee effective monetary policy; all autonomy does is establish a layer of credibility at the outset. But it is conduct that ultimately confirms it.

Autonomy depends a lot on how an MPC member or Governor sees his mandate, and how willing he or she is to use independent judgment and handle pressure from the government. We all know that both Subbarao and Rajan came directly from the finance ministry, but neither of them showed undue willingness to ingratiate themselves with North Block.

Autonomy also is the result of how you negotiate disagreement with the government. The best way is to disagree in private and exude trust in public. In a sense, Rajan’s outspokenness on non-monetary issues may have generated mistrust in the finance ministry, and this could have been the reason for his exit. Patel, who has chosen to keep a low profile so far, may thus end up having more trust and operational autonomy that one may believe.

He looks like the right man to helm of the MPC in its initial years.