#dnaEdit: A welcome move

The finance minister, Arun Jaitley, has gracefully conceded that setting the interest rate is best left to the central bank. He made an observation to this effect after addressing the members of the Reserve Bank’s central board last Sunday. This sets the tone for the relationship between the central bank — that is, the RBI — and the Union finance ministry.

The new tone of understanding is welcome, particularly after the bitterness between the two during the tenures of  P Chidambaram at the finance ministry and Duvuuri Subbarao at the RBI. 

To recall, exasperated with RBI’s rising interest rates — despite suggesting a cut — for thirteen consecutive times when the Indian economy was passing through one of its worst troughs, Chidambaram had observed that the government “would walk alone if need be to lift the economy”. Subbarao retorted that in his lonely walk the finance minister would one day hopefully admit that “Thank God, there was RBI” —  presumably to take care of inflation. This battle had played out when the economy was sagging and inflation was spiralling.

Today, the situation is better. The prices are showing moderation though the economy is still sluggish. Maybe, the concerns and priorities of RBI and finance ministry are converging. But then, the relations between these two stewards of the economy are not always convivial. 

There are two aspects to this relationship. One is technical — the nuts and bolts of setting monetary policy by the central bank. The other is the political aspect of the relations between a central bank and the finance ministry. 

At the technical level, monetary policy setting has undergone a transformation globally from being based on judgment and hunches to the current practice of basing it on a fair amount of analytical work. The technical competence and use of sophisticated econometric tools for setting monetary policy is phenomenally evolved now compared to what it used to be a decade ago. 

The RBI has been moving towards an increasingly analytical-model-driven process for setting monetary policy, as is the practice in most of the advanced countries. Those models depend a lot on current literature on policy setting and some of these studies have become almost like gospel truth for both central bank policy makers as well as the vast body of financial market analysts and operators. Take for example, the so-called Taylor Rule which is an empirical study of central bankers’ responses in certain macro-economic circumstances. Markets expect central banks to follow these for the sake of predictability.

Given the complexities of a modern, globally integrated and growing economy like India’s, setting monetary policy is complex. It can neither be mechanical and in line with  the experience of other central banks. Nor can it toe a set political line.  An economy is a “complex animal” and setting monetary policy has to have a sense of judgment about it. It is in this context that monetary policy is best left to the expertise and the judgment of the central banker. The reason why we welcome Jaitley’s assertion about the independence of the RBI in setting its policy parameters.  In our present context, Governor Raghuram Rajan had given an inkling of what he proposes to do with his “conditional statement”:  He has ruled out any further hiking of interest rate if the economy stayed on course.