Current Affairs: RBI Independence (Monetary Policy Committee)
Hello! And welcome to a discussion on RBI independence. This is an important topic that’s arising because of the debate about the new Monetary Policy Committee. It points us towards 2 important aspects of any central bank – Independence and accountability. Both are very important and independence is vital as we will see; so is accountability. So how do we resolve all these 2 objectives and make sure that the Central Bank is capable of tackling the issues that it faces meeting the objectives that it is supposed to meet while at the same time remaining accountable to the people. This is the dilemma that we are trying to solve in this discussion which the Monetary Policy Committee is also intended to attempt and solve.
So the main learning objectives in this discussion are as follows. First we will briefly define Monetary Policy. We will not get into the details of it because it’s anyway part of a main Economic course and it’s covered in detail there. Then we will look at RBI’s current policy making structure and the institutional dimension of Monetary Policy formulation which means how is Monetary Policy created, formulated and executed in India. What is the institutional mechanism behind them? That we are going to have a look at. Then we will assess all the arguments for and against the independence of RBI. And then finally we will look at the new Monetary Policy framework that is gradually evolving, taking shape and compare that with many international experiments that is already gone before. The effectiveness of those international experiments vis-a-vis the requirements specific to India. So by looking at those examples, we’ll get a better understanding of how we can move forward in our own country.
So now let’s have a look at the major functions of RBI, in particular, the Monetary Policy making functions. Now RBI is a Central Bank of India and it performs all the functions supposed to be performed by a central bank. This includes some regulatory functions which means regulating the economy or regulating other players in the economic system. The most important among this is that RBI acts as a monetary authority in India. Which in turn means that RBI is a complete authority as far as Monetary Policy is concerned. It not only makes the rules, not only implements them but also monitors them. Whereas if you think in terms of the political structure of India formulation is done by legislature, implementation is done by the executive and monitoring is done by the judiciary, whereas here RBI is doing all three functions. What is the objective of Monetary Policy itself? Primarily maintaining price stability and ensuring adequate flow of money and credit to required areas. This is what RBI tries to achieve through its Monetary Policy. Maintaining the overall stable level primarily through controlling the interest rates RBI does this. Now as said before we’re not going into the details of this in this particular discussion. Now the other functions of RBI are, it acts as a regulator and supervisor of the financial system. It prescribes the broad parameters and rules for the other banks to function. And all that is done so as to maintain public confidence in the system. So, RBI puts some rules to the banks to follow so that banks maintain the trust of the public. Similarly also RBI acts as a regulator and supervisor of the payment systems so that public trust in the payment system is also maintained. These other functions of RBI except for the monetary function is anyway discussed in great detail in the tablet course for students and the tablet course can refer those videos. Other students can refer standard textbooks to get access to this. Further functions include manager of foreign exchange. It manages the FEMA, Foreign Exchange Management Act, so as to facilitate foreign trade to develop Indian trade as well as to maintain rupee stability in the foreign exchange market as well. RBI is also the issuer of currency because it is controlling the money supply in the country, so it issues currency and also destroys currency. Both these things RBI does. Specific to a developing country RBI also has a development role in which it tries to promote what the Government is trying to do with the development agenda. It also has some major banking functions such as being a banker to the Government, being a banker to other banks and even being a lender of last resort in the economy.
Now let’s quickly come back to the Monetary Policy Committee and get a quick understanding of how it functions. The various instruments RBI uses are the following. The reserve requirements, official interest rates, open market operations, direct controls. We are not defining these instruments here. All of those are part of the RBI discussion in the main economics course. But some of these instruments are used to meet certain operating targets. Operating targets means initial targets. So RBI tries to hit the initial targets first. These are the short term interest rates. What are the interest rates prevailing in the country right now. The reserve aggregates – how much reserve money a bank is holding. Reserve money is money that is not supposed to be lent out. And then with these RBI tries to hit the next intermediate target, which is, monetary aggregate, which is the amount of money supply in the country, inflation rate in the country, CPI, WPI etc. and exchange rate which is in the foreign exchange market. So RBI tries to use these tool to influence these targets so as to influence these targets and finally hit these goals of RBI. So RBI has these goals. Price stability, sustainable growth, high employment, financial stability. So these goals have cannot be directly achieved. You’ve to go through all these targets to be able to hit the goal. So it is very difficult to hit that goal and we don’t know exactly how the goal goes. We can never predict exactly what will happen. So we’ll have to in turn look at the goal post which is constantly moving and then adjust our strategy this way. So tactics goes this way and strategy goes this way. This is how the Monetary Policy works. It is a very complex procedure requiring expertise which is why it is given to an expert body such as RBI. How does RBI actually implement this Monetary Policy? It has to observe the economy. These goals are nothing but the macro economy so it has to observe the economy, then create certain strategies, then employ the tactics so as to achieve your goals. So this is the approach RBI has to take.
Now let’s look at the RBI’s policy making structure. The RBI first has a central board of directors. It also has some local boards from Mumbai, Kolkatta and New Delhi etc. In the central board the most important person is the governor. The governor is assisted by the deputy governor. Below the deputy governor we have other people like executive governors, we have the central office department which has all the managers and we have also certain training establishment which provide the staff to RBI because as we said we need experts. So trained experts will keep on coming into RBI. This is the policy making structure. So the central board of directors in appointed by the Government of India and it is in keeping with the Reserve Bank of India Act. It will consist of 20 members and the most important constituents of the board are 1 governor, 4 deputy governors and 15 directors. And all of them are appointed by the Government of India. In addition to this as we discussed there are local boards for each of the four regions of the country and they are also appointed by the Central Government.
So now let’s look at how decision making is done in RBI and is there an accountability present? How is the current system achieving the goals that we want to achieve? So let’s examine the current system first before examining the proposed systems. So the existing mechanism is as follows. The finance minister selects the RBI governor approved by the Prime Minister and finally appointed by on behalf of Government of India. The term is for 3 years and the RBI governor can be reappointed. RBI governor or RBI in general is accountable to Parliament’s standing Committee on Finance. They can summon the governor and ask for explanations about the Monetary Policy. So if the standing Committee on Finance is not satisfied, they have the right to summon the RBI governor and demand explanations. So on behalf of the people of the country the RBI governor can be held accountable. So accountability is being maintained to that extent here. However, at present the Monetary Policy is made by the governor alone. The governor has supreme majority in India. He does this in consultation with the deputy governors as well as Technical Advisory Committee. The Technical Advisory Committee was formulated in 2009 to assist the RBI governor. So why Technical Advisory Committee? Because highly technical natures we need a lot of experts. So these experts aid and advise the RBI governor. However, they are only advisory in nature. RBI governor also consults with important bodies like FICCI CRISIL etc. so as to get a good understanding of the sentiments in the business sector of the country. In addition to all this RBI also publishes the annual report on the official website for public discussion and for transparency. So a good amount of transparency is being maintained in the current system itself. Now this structure of the RBI makes it one of the most independent agencies of the Government. It is comparable to Supreme Court in terms of independence that it commands. However RBI governor is appointed by the Government of India so that is one notch below in terms of independence. It is also one of the most independent Central banks in the entire world. Now there are two different viewpoints about the RBI. One is that RBI has too much power and should be controlled more by democratically elected Government. The question here becomes how can so much power be vested out in non-democratically selected person such as the RBI governor? So one viewpoint is we have to control RBI’s power so that democratically elected Government has power over RBI, or power over the Monetary Policy making. Another viewpoint is RBI should remain independence or else politicians including the Parliament and the Prime Minister’s office could order the RBI to boost money supply, increase credit etc. just before an election for example. So Government could misuse Monetary Policy for its own purposes because of that RBI has to remain as a separate institution. That is another viewpoint.
So first we are going to examine the 2nd viewpoint that RBI should be independent. So what is the case for Central Bank independence? The first is that RBI avoids inflationary spending by the government. The government might spend more to meet its own political agenda, such as, spending more before an election so that people have a perception that the country is improving etc. So government can sell this by forcing the banks to buy bonds so that the government can spend more. This is banned because this can lead to inflation very fast. So one reason an independent organization is good is that this kind of problems can be avoided. And we can avoid the use of Monetary Policy for political goals. Monetary Policy is a powerful tool which should be used only for the goals that you have already sought, high stability etc., not for political goals, not for winning an election. So we cannot lower interest rates before an election so as to win an election. We can only lower the interest rates when we feel that the inflation is low enough to allow that. Otherwise, the election will in turn cause inflation. This used to happen quite often. The election cycle used to be matching with the inflation cycle but independent RBI can control this kind of mismatches. Now let’s look at the theory behind why governments might always end up misusing Monetary Policy. If the government is given power over Monetary Policy, governments have a tendency, automatic tendency to misuse that power.
So let’s see how that happens with a bit of theoretical understanding. So an important concept in economics something called the Philips Curve. It tells us the relation between inflation and unemployment. So Philips Curve tells us that the inflation and unemployment are inversely related in the short run. So forget the straight line curve for now. Focus only on the blue curve. Initial Philips Curve, short-term Philips Curve. Only on that curve and let’s see what happens. So right now we are in point A, imagine. The political parties, they want to reduce unemployment. So in the short run if you move from here to here. Suppose you bring more money etc. you move from here to here, inflation increases because money is increasing. The amount of money in the country increases, inflation increases or price increases. But unemployment reduces. You wanted to reduce unemployment so you’re moving like this. A to B you’ve moved. So first step is moving from A to B. And what have you achieved? You’ve achieved lower unemployment at the cost of higher inflation. Now governments always tend to do this because inflation is a more spread out process. Unemployment if you can reduce you still tend to get more votes. So governments want to reduce unemployment, they tend to sacrifice inflation for that and we reach B. However, in the long run the newly employed people will realize that everything is now more expensive. When everything is more expensive the current salary is not able to help me buy all the things that I require. So soon they’ll start agitating for higher wages and we’ll move from B to C. When the wages increase the companies can’t employ as many people so unemployment starts increasing again. So we start moving back and then in the 2nd step we move from B to C. Now what have you achieved. We have gone from P1 to P2 in terms of price level and we’ve gone from employment 1 to employment 2 in terms of employment levels. We’ve gone from employment 1 to employment 2, reduce unemployment, we increase price, then the price is still fixed in P2 and we’ve reached back to employment 1 stage. So what have we done? We’ve reached point C now which is high price and same unemployment. So what have we achieved? Nothing. Now this is not the end of it. The story will continue because again we’ll keep on doing this. From this again we’ll move up and again we’ll move up, again we’ll move up, again we’ll move up etc. etc. until inflation keeps on increasing and unemployment remains constant. Because this long run curve means that this is the highest the economy is currently capable of employing anyway. So these aspects we’ll discuss further in Economy lecture so do not miss those lectures where we’ll discuss structural policy, how to improve the long run curve etc. But in the short run as we can see Philips Curve tells us governments will tend to sacrifice inflation for unemployment and in the long run inflation will keep on increasing if you allow governments to control Monetary Policy. Which is why we need somebody to control Monetary Policy who’s focused on inflation rates alone. And that is role of a Central Bank.
Now if you look back in history. You’re going to look back at German hyperinflation just after the First World War. What happened? Government started printing more money so as to pay back the debt it owed. So the government is paying back its own debt by printing more money. Now the more the money is printed, the less the value the money, inflation starts rising like anything, hyperinflation happened. So whenever government tries to finance their debts using Monetary Policy, hyperinflation can result. So we have 2 big dangers happening there. One is that when governments try to please the population by reducing unemployment, inflation can happen. Second is, and the government tries to reduce its own debt by printing ore money, hyperinflation can happen. So both of these things tell us that governments are bad custodians of Monetary Policy which is why world realized it’s important to have an independent monetary authority and that power was taken away from the government and given to central bank across the world. And that has turned out to be an important information because throughout the world inflation increases when central bank independence reduces. And we’ll see this through data points.
So how do we measure Central Bank independence? We have a Central Bank Independence Index in which these various questions can be asked to see if the Central Bank is independent or not. Political independence means appointment etc. In political independence Indian Central Bank is not completely independent because appointment is done by the Government. However, Government is not currently part of Monetary Policy formulation so there political independence high in India. Now if you look at economic independence it’s pretty much high independence in India. So these are the various questions that can be used to calculate, to understand whether any central bank in the world in country is independent or not. So based on this we can plot the various central banks in terms of the independence. So here you can see inflation rates increases, here you can see independence increases. Now as you can clearly see from this diagram, when independence is very low, inflation is very high potical. As independence increases we can see inflation starts coming down. So Germany is the most independent central bank and there the inflation is the least. Low inflation automatically means high independence of central bank. So data suggests that independence and inflation is, have high correlation which means as independence increases, inflation comes down. So the best way to reduce inflation is to increase independence. Which is why central bank independence becomes an important concept. Now, having understood the theory behind central bank independence is important, let’s also look at another aspect of it. Because governments want that power, governments have a tendency to try to take that power from the central banks. Multiple times a government want to take that power because it is like a big khazana sitting there. I can use Monetary Policy to win elections, I can use Monetary Policy to finance my debts. It is such a easy thing that is sitting there. Governments are tempted to use that. However, that khazana, treasure has been taken away from the government and given to central bank. However government will every now and then try to put the hands into the treasure box and take some of the candy. Take some of the treasure to use it themselves. And that is what we can see if you quickly look through the history of how the Monetary Policy Committee has evolved in India.
So first step was FSLRC – Financial Sector Legislative Reforms Commission. It proposed a 7 member Monetary Policy Committee. You know, what does a Monetary Policy Committee mean? It means that instead of a single RBI governor we’ll have a committee of people who’ll decide Monetary Policy. So this was in March 2013. Now it’s important to now that irrespective of which political party is in power the government will always have a tendency, a temptation to try and take some power Monetary Policy. So as we can see in 2013, which is when the previous government was in power even then the process had started. So no matter which political party of which government is in power, this temptation is a fact of governance. It’s proposed, in the first FSLRC report proposed a creation of a Monetary Policy Committee that will determine the policy interest rate. So, there will be Chairperson and one executive member of the board and MPC would have five external members. So there will be a Chairperson, which is the RBI governor himself, one executive member and 5 external members. That is the structure proposed. Of these 5, 2 would be appointed by the Central Government in consultation with the Chairperson while the remaining 3 would be appointed solely by the Central Government. We have 2 external members selected in consultation with governor and we have 3 purely by the government. So in effect we can say there is a 4:3 ratio between RBI and government, which means RBI will have a majority. So under FSLRC commission report, RBI has a chance for a majority there. RBI governor in addition will also be given the veto power over all MPC decisions under what is called extreme circumstances. RBI not only has a majority here. It’s a 4:3 ratio for RBI is to government. RBI governor also has a veto power. The round 2 of the evolution of Monetary Policy Committee’s Urjit Patel Committee which was appointed by RBI itself and they came out with a report in January 2014. They proposed 5 member Monetary Policy Committee. In that the governor of the RBI will be a chairman of the MPC, the deputy governor will be the vice chairman and an executive director will also be a member. Two other members, which means 3 from RBI and there will be 2 other members who’ll be external to be decided by chairman and vice chairman. Which means again RBI is going to be involved in the appointment on the basis of expertise. So we’ll have a 3:2 ratio RBI vs outsiders. Government intervention will not be there. So we have a 3:2 ratio with RBI having majority and 2 experts. So we can say RBI is to expert’s ratio. This experts will in turn be selected by RBI itself. So we have a situation in which RBI has, still has complete control. However, there is a committee in place. So even if the external members disagreed RBI governor will still have a 3:2 majority, so RBI governor has still complete control over Monetary Policy. Now why is this control for RBI governor important? Because without that there won’t be any credibility. The market reacts to RBI governor. So the fact that RBI governor can control the Monetary Policy is what market reacts to. If you take that power away from RBI governor the market will not be having trust in the RBI which means the market will tend to be more irrational, more jittery. Which is why it’s important to project the image that RBI is in control. This report also advocated inflation targeting along with MPC. Now we will see inflation targeting a bit later in the discussion and we will see that that has been adopted. So this is the Urjit Patel Committee structure. We have 5 people in the Committee. The first two, Chairman, which is the governor, and the Vice Chairman – any one deputy governor because RBI has total of 4 governors. There will be 3 external members. One insider, RBI’s own Executive Director. And 4 and 5, the last two, will be outsiders or external members. So we have a 3:2 ratio. There will be experts. They will not be eligible for reappointment. No officials from government is present which is important feature of this proposed structure.
Now the response came from FSLRC which came out in July 2014. They again recommended a 7 member MPC but this time they are more stringent. Government is trying to take even more power from RBI and which is where a lot of controversy erupted out. So according to this there will be 3 members from RBI and 4 external members nominated by the Ministry of Finance. So we suddenly have a 3:4 ratio between RBI and government under this proposed architecture. There will be no extreme circumstances, there will be no veto powers. All the power has been taken away from RBI in this final round 3. In this round which is why a lot of controversy came out. So immediate controversy happened because this looks as if government is trying to take away all the power from RBI. Because if 3:4 ratio is there, then the government will have complete control over the Monetary Policy and as you’ve seen giving government control over Monetary Policy is always dangerous. So this is part of the Draft Indian Financial Code (IFC). The actual official language is as follows. So we will have a Reserve Bank Chairman as a Chairperson, one executive member of Reserve Bank also nominated, one employee of Reserve Bank nominated by the Reserve Bank Chairperson and 4 persons appointed by the government, 3:4 ratio. Government will have a clear majority in Monetary Policy Committee in this particular structure. It also proposed to take away some other powers of RBI so government is encroaching more and more into RBI territory here which is why this led to a lot of controversy in the economic circles. The two biggest criticisms of RBI which has been there for quite some time are the following. Now what does accountability mean? The goals of monetary policy are not clear. So when you don’t achieve something how do you know whether you have achieved or not unless the goals are clear? So the one reason where accountability is considered to be less. Second is, there is a lack of clarity of responsibility of governments in RBI. So what the RBI supposed to do? RBI is supposed to develop, RBI is supposed to follow government’s development agenda which would mean reducing unemployment or RBI is supposed to follow price stability which it actually mean increasing unemployment in the short run sometimes. Because when you try to reduce inflation, unemployment can go up. So these are contrasting motives. So when you have contrasting motives you can say I was not able to achieve this because I was trying to achieve this. I can say I was not able to achieve this because I was trying to achieve this. So when I give two objectives to somebody, say I tell somebody to be good at math and football, there will always be a ready-made excuse that I was not in good math because I was learning football; I was not good in football because I was learning math. Now this is the problem that is which is why define the goals and define the direction better. Only then accountability can come. The second is lack of transparency. S. S. Tarapore Committee was very clear, the current monetary policy formulation in this country cannot be continued indefinitely because there is a lack of transparency about goals, the lack of transparency about why it is not achieved, there is a lack of transparency about what is the thinking behind things? So they said we greater transparency in policy formulation and transmission process, how the policy reaches the final goal, which is through the intermediate targets. And these has to be clearly demarcated. So this is somehow reforms required to make RBI even better. RBI is a wonderful institution which has been doing a good job. We are to make it even better. These are two things geared at you – accountability and transparency. Independence is already there. We shouldn’t compromise on what is already there also. How to achieve both at the same time. How do you increase accountability without reducing independence that is the big conundrum right now?
Now what is the case against central bank independence? Let’s have a look at why central bank independence might also be slightly bad. The biggest reason is that central bank is not directly accountable to the voters. What the voters want and what the bank does might be slightly at odds. So RBI might sometimes be implementing monetary policy against the wishes of the electorate. For example, there could be a stack flation situation in which economy is not growing also. At the same time unemployment is high as well and RBI cannot reduce interest rate. Instead it has to hike interest rate because inflation is high. Now the electorate might not appreciate that. People might start feeling why should the RBI have this power, why can’t we decide, why can’t our government decide? So those kind of questions can come. Also government might sometime blame RBI for not allowing India to develop etc. So this is situations in which this accountability issue becomes a problem. And too much economic power has been concentrated in the hands of non-elected people. Another big criticism, Governor, even it’s a board, they are all non-elected. Appointed by the government of course but still non-elected. So how can they have so much power and independence? They should be more accountable to the people, and how to be accountable to the people – you can only be accountable via the parliament. So increase parliamentary accountability is one important goal if you want tackle this criticisms.
Now an important mechanism for tackling these accountability problems have finally come forth. Inflation targeting has been adopted in India so that now we’ll have a clear goal. The moment you have a clear goal you will not be able to give excuses anymore. So we have a clear goal setting which is what is done by inflation targeting. So in February of 2015, the Reserve Bank of India and the government entered into an agreement on a new monetary policy framework. What this means is that the inflation target will be set at 4%. 4% will be the inflation target. RBI is supposed to achieve that. Government will decide the target, RBI has to achieve the target. There will be a band of flexibility plus or minus 2%. 4% is the target, plus or minus 2% is accepted. This will be starting in 2016-17. So Reserve Bank of India will be considered to have failed if it does not meet the target. So if the inflation is more than 6%, its 4 + 2, 6%, if it’s more than that Reserve Bank of India will be considered to have failed. And if it’s less than 2%, 4 – 2 is 2%, again RBI will be held accountable. In consecutive quarters. If it happens consecutively. Occasional fluctuations might be acceptable but consistently, if you are above 4 + 2, or below 4 + 2, you’ll be held accountable for that. Now if the Reserve Bank of India fails in this manner it will have to send a complete report to central government giving the reasons for its failure and all its plans to achieve the target, what remedial measures its going to do etc. so this means now RBI will have to be even more careful, even more active, even more proactive in policy making so as to meet the inflation targets. So this clearly a mechanism for accountability. This gives clarity of objectives. So by clarifying the goals of the Reserve Bank of India, monetary policy framework has enhanced its autonomy in fact too. Why? Because now RBI can say because I am accountable, because I am supposed to meet the goals which the government has given to me, that means I can be more autonomous now. So you can tell me exactly what to do and as long as I am doing that you don’t have to worry about accountability anymore. The control of inflation has emerged as the dominant objective which is an important item. This clarity increases the accountability of central bank. Now to do this we have to amend the RBI Act. So government has promised that the finance ministry officials will be pursuing this soon so that this inflation targeting has not come into effect yet. It is supposed to come into effect only next year but before that amendment is required so that is something we have to be keeping an eye on whether that will happen or not. Now there are some recent developments in the Monetary Policy Committee. Now in the context of having accountability through inflation targeting let’s look at the most recent developments as far as Monetary Policy Committee is concerned. We are going moving towards a consensus on MPC’s composition. What should be the composition of MPC is what has been the debate right? So we are moving towards a consensus between government and RBI. Now RBI has been saying we want independence, government has been saying we want some power. We also want to be part of monetary policy but now they are moving slowly towards a central point that they can meet and agree upon. So RBI governor himself has announced that government and RBI has finally agreed on what the composition of the MPC should be. Which by default assumes that MPC is going to be there. The only question is what is the composition and there also some agreements seems to have been reached. We only have initial vague reports about what that agreement is, so we’ll have to keep our ears tuned about exactly what is going to come out of it. So it is said we don’t know exact numbers or the exact mechanism yet but sources are claiming that it’s going to be a six-member Monetary Policy Committee. So how this is going to work is that government is going to nominate three, RBI is going to nominate three. So government and RBI will have equal representation at 3:3 ratio. A 1:1 ratio. Equal representation will be there so the problem of 1 person having extra power etc. excellent mode. Each of the six members will have 1 vote and RBI Governor in addition to these RBI governor will also be there. He will have the casting vote. What the casting votes means is that suppose there is a decision and 3 people vote yes and 3 people vote no, then RBI Governor can cast his vote as a casting vote, or a tiebreak vote. Only then can the RBI Governor vote. So if the RBI Governor in this case votes for this, then becomes yes, if the RBI Governor votes for this it becomes no. Now C. Chidambrum says that it will be a brave RBI Governor who will always consistently vote against the government. If the government is voting yes so a 3:3 ratio, RBI Governor will need some extra bravery to be able to vote against the government. So this enforces a mechanism in which RBI Governor feels it’s really necessary he can take a stand and vote for no. It’s equivalent to, almost equivalent to veto. However, the Monetary Policy Committee has the actual power. RBI Governor power has been reduced under this framework. Now the inflation targeting itself will not be determined by the MPC, the government will determine that. MPC’s job is only to meet the target. So MPC has to meet the target which is set by the government. So now we can see a lot of accountability has come in. The target, what is your job, is given by the government. So people are telling RBI what your job is. How RBI will do it is again controlled because partly that is again 3 members are appointed by the government. So government is having a direct role not only in setting the target but also in the implementation. So earlier we saw RBI formulates, implements and monitors. Now we are saying formulation will be done, at least the broad formulation will be done by the government. How it is to be done micro formulation will be done by the RBI. Implementation part again there will be a government component to it and monitoring part again government component is there because the parliament will be monitoring this. Because if the target is not meeting the required levels, RBI is to send a letter. So here we can see a lot of accountability has been brought into the system. So that criticism can now be removed from RBI functioning. Transparency also will automatically increase because without transparency accountability is not possible. So as we said the other external members in the committee will be appointed by the government. Now in addition to these 6 members, a finance ministry nominee will also be attending the meetings but he will not have a vote. He will be only there to facilitate, to increase the connection between government and RBI. So he’ll give the, convey to the Monetary Policy Committee government’s views. What the government want. So this is supposed to increase the interaction and the cooperation between RBI and government. So a bill may be introduced in the coming winter session so we can eagerly await to see what the final results will be. Decisions of MPC will be binding on the central bank. In case of a tie, RBI Governor will have the casting vote, as we discussed. So this is a brief overview of the new balance.
Now one important think that you’ll notice is that veto power is not there anymore. So, this veto power has been taken away from the governor under the current framework which means governor has become less powerful. The power of personality in RBI is very important as we discussed earlier because markets are irrational, markets are jittery, so having a powerful figure who is able to influence monetary policy has an impact. So taking away veto might have been a bad move. We have to go forward and see how the market reacts in case of an emergency such as rupee was falling and just the fact that the new RBI governor’s appointed had the rupee climb back up again. Which is because the market expects RBI to take firm action. Now firm action is possible when the RBI governor has more power. So this veto could be an issue. We have to wait and see what happens. Now another thing we can wonder is why is the RBI compromising. Why is RBI allowing 3 government members into the MPC? The reason is simple. Now that inflation targeting is part of the mechanism, the goals are fixed. The MPC supposed to meet inflation targets. That cannot be compromised. It has to be 4 plus or minus 2, right, which means even if government wants to interfere in the MPC, even if government tries to interfere much they’ll still have to meet these targets which means government will not be able to sacrifice inflation too much and the whole Philips curve problem will not be there. So having clear goals allows RBI to compromise on its independence because the monetary policy is now clearly fixed on inflation. So the dangers of losing independence is a bit reduced because of clear targets. Because the moment clear targets is there that is a clear accountability and because of that even if government interferes they’ll not be able to do too much damage. Now if the inflation targets were not there, if MPC was formulated before inflation targets then government would have too much leeway, because development, inflation, unemployment, too many agendas right? Which means government would have been able to easily justify making a few mistakes. But with a clear target, that is not possible. So important thing to remember is that inflation targeting has to happen first. Only then this MPC can come into effect. So if the government tries to push MPC before inflation targeting then that could be bad for the country. With inflation targeting the current framework of MPC seems to be a reasonable framework.
Now let’s look at the rest of the world. How does the rest of the world deal with monetary policy? Now here the continuum is like this. As you go from here to here, central bank power increases. So here at this point it is almost completely government controlled and this point it is complete central bank controlled. So as you can see a lot of these aspects do they have a special monetary committee, is there an MPC or not, we can see sometimes its yes, sometimes it’s no, sometimes its yes. In fact throughout the spectrum there is a lot of yes and no’s. This shows the composition, the total numbers, how many are from central bank, how many are from external and how many external appointment is by government. So if we compare this versus this, we’ll have the government to central bank ratio. So as we can see, when the central bank is 1 and the government is 6, we have the least independent central bank in Philippines. When the government is 7 and the central bank is 2, we have again very dependent central bank. However, if you look at India we don’t even have a MPC. We have only 1 from central bank and nobody from government, complete independence. We have one of the most independent central banks. If you see Urjit Patel Committees’ recommendation that would put India somewhere in this spot, which means less independence not completely independent. However if we go for the FSLRC versions we’ll be all the way here mostly under government control. So current is we are all the way here with complete central bank independence. Government is trying to push us all the way here. Urjit Patel is saying we’ll stand somewhere here and under the new proposed architecture, we’ll come somewhere in this side. As we can see, a new proposed architecture will be very similar to UK’s architecture which is a 5:4 ratio. So we will examine UK in more detail to understand the current architecture a bit later. Now if you see New Zealand is having a situation in which central bank will have 6 to 9 members and there will not be any government control at all. Now we have seen central banks across nations there is no uniform organization, there will not be, there is no uniform targets, there is no uniform policy making structure etc. and New Zealand was a pioneer in adoption of inflation targeting, okay, which became a model for others to follow. However, New Zealand did not have any committee etc. This clearly shows inflation targeting itself is enough for accountability. Committee is not always required. However, if committee is there, it is good to have inflation targeting also. In New Zealand the tenure of the Governor itself can be reduced if inflation target is violated. So that is how strictly accountable the governor of the RBI, the central bank is held. So that can also be a model to follow. Now in developing economies, typically inflation targeting was followed by developed economies such as European Central Bank, America, USA etc. but it’s now being adopted by lot of developing economies also. So South Africa and Brazil were some of the pioneers in developing economies. Now India is also following in their footsteps. Now Brazil has had problems in maintaining the inflation targets because inflation is not entirely dependent upon monetary policy. There are lot of structural issues which the RBI cannot really control, central bank cannot really control. These issues are discussed in more detail in the tablet course. Please have a look at those videos to understand this better.
Now let’s quickly look at the other big banks, the other big economies. The US Federal Reserve has the following situation. It has set a benchmark rate which is a target the federal funds rate is called. It is set by the Federal Open Market Committee. It’ll have seven board members. It’ll be appointed by the President and confirmed by the senate. So this is the structure of the US Federal Reserve, FOMC. It’s 12 members and each gets 1 vote. There it is not purely based on voting. It is mostly on consensus. Any persons who are having differing views will be published for the sake of transparency.
The Bank of England which is very close, very important to us right now, it is very close to the current proposed architecture. Their monetary policy committee is made up of nine members, as we saw in the diagram also. We’ll have governor, three deputy governors and a chief economist. We have five from central bank and four from government. Now these four members are independent and does not represent any interest groups. That’s very important. They are appointed for fixed term and each member of the committee has one vote. Now here also the member of a treasury which is from the government, a government representative is sitting in the policy meetings but he does not get a vote. Now as we will see later this is very similar to the current proposed architecture.
Now European Central Bank is slightly different and more complex and because it is for the entire Eurozone. It brings together representatives from all the different Eurozone nations. So there the council consists of six executive council members and nineteen representatives. The executive board members have permanent voting rights. So total of 21 voting members. Each of them gets one vote each. So here also it is mostly on consensus based even though voting is taken. So they try to achieve consensus and that kind of policy decisions are taken.
Now what are the targets in these various countries in terms of monetary policy? Do they have targets such as inflation targets? What is the monetary policy supposed to achieve in these countries. Let’s have a look. In US no targets are set. FOMC is there, they’ll work on a broad consensus and try to achieve that but no strict targets are kept. They only go for a benchmark rate. In Euro Area, ECB defines price stability. It’s defined as close to 2% in the medium term. So, this 2% is held as a target mark. In England again a clear target of 2% is there. The Central Bank is accountable for maintaining this rate. In Canada it’s 1 to 3 percent, a range is there. It is done by the government and the Bank of Canada. In Japan, the Bank of Japan is independent. It fixes its own targets it will have. And the main target is 30 to 35 trillion yen in the current accounts target. And Japan’s tackled it slightly different. It’s having a current account balance target. But it’s fixed by the Bank of Japan itself.
So these are some of the diverging ways in which monetary policy has been conducted across the world. So as we can see there is no hard and fast rule. The important rule seems to be independence has to be maintained, accountability has to be maintained. Independence will be maintained by reducing government interference. Accountability can be maintained by giving clear targets. Now if you again look at the entire world we can see majority of them have monetary stability and have a non-conflicting targets. Some of them Monetary stability and conflicting targets. Now India was here earlier. Some of them don’t have any goals altogether. Some of them have only non-monetary stability and some have only monetary stability. So in moving from here to here if the current proposal is coming to effect we’ll be moving from A to B.
So based on this entire discussion let’s come up with a framework for evaluating monetary policy process itself. How do we evaluate transparency of the monetary policy committee or the central bank? One thing is are changes in policy announced? If it is no, it is less transparent. Is the vote published of the monetary policy committee? If the answer is no it’s less transparent. Are minutes of the policy being released? If the answer is no, again it’s less transparent. Are they clear targets? If the answer is no there is no accountability. Is there a monetary policy committee? If the answer is no that means too much concentration of power possibly. Is there government interference? If the answer is yes, probably too less independence is there. So these are some of the ways of evaluating monetary policy. So these are all the questions to be asked. Transparency, accountability, independence.
Now let’s look at the indicators of transparency in these various places. FOMC, ECB, BOC, BOE etc. The table is there it’s very. Please have a look at the table to understand this if only for data purposes.
Now let’s zoom in on the UK monetary policy framework because that is the closest parallel we have found in the entire world which is close to the current architecture being proposed. So in Bank of England from May 1977 onwards an MPC was formulated just like India is planning to right now. There MPC meets every month to set the rate of interest. Set the rate of interest so as to meet the targets. So primary goal is to set the rate of interest. The UK Monetary Policy Framework for Bank of England is pretty similar to what is presently being proposed which is why we are discussing this in detail. So membership of the MPC, as we saw, is Governor and two Deputy Governors, which is three members there, plus two Bank of England members appointed by Governor in consultation with Chancellor which is again two people. So all this from the central bank and four external members from government. So we have clearly a 5:4 ratio. And we have one Treasury representative without a vote who is only there as a facilitator, to achieve coordination of monetary policy and fiscal policies. So does it always achieve? It will be better and without a representatives. Having a representative there can help coordination. Now objective is price stability. It’s not an end in itself of course but this is a prime target given to them. Now credibility is attained in the market. Market credibility is primarily for the market. The market has to believe that the RBI can act, the central bank can act. It’s attained because pre-commitment is there. The government and the RBI is committed to a 2% interest rate just like we are going to be committed to a 4% interest rate. That means the market is going to trust more. Inflationary expectations will be less in the market. And they have system of constrained discretion. This is not pure discretion which means not complete independence but there are rules as well. That constrained discretion is what we are aiming for right now. Now the government retains overall responsibility monetary policy. It designs the framework, it sets the inflation target and once the inflation target is set, then it is a technical issue. Then experts are required which is why then the monetary policy committee will take over and decide what is to be done to maintain the inflation rate. To maintain the 2% inflation rate. So MPC is responsible for setting interest rate to mean the inflation target which in turn is set by the government. So MPC is accountable to the Parliament. Scrutiny is exercised by the Treasury Committee and Lord select Committee just like we have the standing committee on finance. Now if the target is not met, then just like we have in the current architecture related to Chancellor’s required in which the reasons what action is going to be done etc. has to be clearly delineated. A second letter is also required if after three months inflation target is still not being met. So accountability, credibility, individual reputation is also important. These are all being maintained because publication of MPC minutes, Inflation Report, speeches by MPC members, all these things along with clear target helps us maintain these requirements. Now inflation targeting is not a panache, it is not a cure all. It will also have some problems. The main problem will be that there will still be the differences between MPC and the government. The central bank and the government might still diverge. Fiscal policy and monetary policy might not always be coordinated in spite of a representative sitting there. So there is still a possibility of conflict. However, the fact that MPC is there could be a good platform for coordination as we already discussed. Treasury observer who is present there will be able to coordinate even though he has no vote. Now please note that appointment of new MPC members and setting of inflation objective everything is with the government. Only the actual monetary policy of setting interest rates is under MPC. So MPC’s power has been constrained to a very small segment. Now as we saw an independent monetary authority is required if you want to sidestep Government induced inflation, because government should not be allowed to run MP. We saw the governments are not good custodians of the money supply or the monetary policy. So most economies realized this and saw the need for a separate institution to do monetary policy. So across the world independent central bank setup because the countries realized this. It is why independence is significance. We cannot compromise there. But countries have also, as they grow, policy making evolves all the time. So as we have grown we have also seen that independence is not the only thing. Accountability is also required. Because accountability is required more and more countries are now going, attaining that through MPC, inflation targets, parliamentary oversight etc. which is exactly what where we are also moving towards. So it’s a correct direction to move towards. Now Raghuram Rajan, the current RBI Governor himself has said MPC is good for policy making and he has three interesting points to make about it. One is having a committee allows for diversity of viewpoints. Just having somebody to criticize you, to point out the flaws in your argument might make your argument stronger, might make you change perspective of things. So we can have more informed, more adaptive policy making with the MPC. It will also reduce undue pressure on RBI Governor. If one person is making all the decisions there will be too much political pressure on him about what if you’re wrong, but if it’s a committee of experts making decisions, then the responsibility is a bit spread across them so they can make more bold decisions. So a single RBI governor might not be willing to take bold decisions but as an MPC we will be able to make bold decisions because responsibility is spread across now. It also ensures policy continuity. So normally when one governor changes, the next governor comes to power, we don’t know how the next governor’s thought process will be like. So there could be complete policy change altogether. Now the next governor might decide that it is more important to be more aggressive on inflation, the previous governor might have been more relaxed about inflation etc. However, if a monetary policy committee is there, it’s tackled retirements, that means there will be some policy continuity because majority of the people will be from the previous regime.
So all this brings us to an end point which is a compromise solution. The compromise solution should have the following characteristics. It should have an independent and credible monetary policy committee. Independent means government should not be able to exercise full control over it. Central bank should be able to assure the market that we will be taking required actions. In addition there should be clear parliamentary accountability with clear targets. So targets and accountability is also required in any kind of compromise solution that we move towards. And more official interface between the executive and the monetary policy committee will also be useful. So these measures allow us increase accountability and transparency. Even while maintaining the sanctity of the independence of central bank. As we have seen that is too crucial to be sacrificed and the current proposed structure seems to be promising that. So we are going in a positive direction, a very promising direction right now.
Now as we try to drive home in all our classes, it’s most important to be able to frame questions. We should be able to frame questions so that you’re able to revise well and practice well. No topic is complete unless you have been able to frame good questions and practice them and revise them. So keep developing your question framing capacities. A few sample questions have been provided here. Please frame your own questions according to a metric and please post them in the comment section. As we know questions can be static conceptual, dynamic conceptual, static analytical and dynamic analytical. Questions can come in only these four varieties. Primarily UPSC focuses on static analytical, dynamic analytical. Static analytical is the answer doesn’t change all the time. Dynamic analytical, the answer changes all the time. Analytical means you have to analyze the answer. Conceptual means you have to present the concept. So let’s look at a few questions of static analytical essay and DA versions and then please practice your answer writing using these questions and post in the comments section or you can send it as a mail to us and we’ll respond with comments on how to improve etc.
So first let’s look at a few static analytical questions. Discuss the monetary policy of India. How is RBI as an independent regulator effective in implement it? Now the word independent comes, that means it’s a clue to you how the question is coming. It’s coming because of the question of non-independence arising through MPC. So you have to be able to discuss this question defining the monetary policy well and in good detail and showing the importance of RBI independence. Here we like to give the historical context. We like to talk about the Philips Curve, we’ll talk about debt at hyperinflation conflict. All those things has to be brought in to make this a complete answer.
What is the role of an Independent Central Bank in a well-functioning economy? What are the dangers of government overreach? So again a similar kind of question differently phrased. Why is an independent Central Bank required for good functioning? What can be the dangers of government overreach? We like to talk about again talk about hyperinflation, debt financing, monetizing debt etc. to give a complete answer to this question. Please do, again I repeat, please do practice your answer writing to these questions, post in the comment section or email to us.
Now let’s look at couple of dynamic analytical questions as well:
Discuss the proposal under consideration regarding MPC. What are the pros and cons of clipping the wings of RBI? Here it’s a dynamic question because this current proposal might keep on changing. So one year ago it could have been the FSLRC commission report, a bit later you could have the Urjit Committee report, now currently we have to discuss the latest cabinet note which is being circulated and discuss the pros and cons of that. We have to first discuss are we clipping the wings? Is it bad to clip the wings? Clipping the wings means reducing independence and finally what are the pros as well.
Critically discuss the importance of independence vs Accountability when it comes to a Central Bank or Regulator. Discuss options which would allow Govt. to maintain an arms-length from regulation and still ensure accountability. So here you have to give a complete solution package. So you should be able to say the importance of independence, importance of accountability and how to do both which is what we have done in this entire discussion. We have found that the independence is possible by maintaining RBI credibility and RBI majority in the monetary policy committee itself and accountability can be maintained by giving clear cut targets with penal measures if the targets are not met.
So this is the way to approach any current affairs topic. Please do frame the questions in a very, very organized and structured manner and practice your answer writing skills. So thank you for listening to a discussion on RBI independence. All the best.