ANALYSIS. Monetary Policy Framework, an attempt to fix responsibility

An important managerial principle is that assigning and fixing responsibility unambiguously is the first step in getting desired results. In a sense, the monetary policy framework that has been signed between the Finance Ministry and the Reserve Bank of India, is an attempt to fix responsibility for controlling inflation on the RBI. By giving the RBI a clear target of keeping inflation at close to 4 per cent, the government is making it more accountable. If inflation goes below 2 per cent or above 6 per cent, the RBI will be deemed to have failed and must explain why.

Inflation targeting is a way to bring focus to the central bank’s task of maintaining price stability. This is not to say that from here on, the RBI will not care about growth or about exchange rates or about achieving full employment. However, what the framework seeks to do is to assign priority to the one objective on which it is most frequently judged and then be held accountable. As things stand today, the RBI has a multiplicity of objectives, which are also some in conflict with each other — and this serves to confuse every one.

The RBI’s role as debt manager for the government (and its natural bias towards keeping interest rates low for the government), its role as guardian of the exchange rate and forex reserves, its role as regulator of banks — these often tend to be mutually contradictory and lead to policy failure or weak transmission.

This has also led to a charge that the RBI is always evasive and never accepts responsibility for its policy mistakes. In asking the RBI to focus on a defined inflation number, the government is now clearly establishing a benchmark against which the RBI will be judged. This by itself is a momentous step. The credit for this must go to the Governor, for being willing to accept that responsibility.

Both the government and the Governor have used the opportunity provided by a set of favourable factors such as lower commodity prices and weakening inflation, to embed this into an institutional arrangement.

The key question is — what will happen if and when commodity prices move up, say oil prices touch $100 a barrel, and the government is forced to hike prices repeatedly? If the government doesn’t move to curb subsidies or control its expenditure, and inflation moves up, what happens then? Then the 4 per cent inflation target for the RBI will go for a toss. Or, if the next year sees $75 billion flowing into the economy, will the RBI stay away from sterilising the inflow (and stoke inflation) or will it let the rupee appreciate (and let the powerful exporter lobby scream?)? Will the RBI still accept responsibility for meeting the inflation target or will it pass the buck to the government itself? These scenarios are now in the realm of speculation, but could well play out in a year or two from now. This may end up giving the framework a bad name – unless the political leadership is sensitive to the true implications of this agreement.

There are some who wonder whether the agreement will erode the RBI’s autonomy. That is a difficult question and the answer can change depend on who you speak to. It might be worth recalling what YV Reddy, former RBI Governor, was fond of saying,“The RBI is an independent institution. I have the Finance Minister’s permission to say so!”