#dnaEdit: Monetary designs

The Union finance ministry and the Reserve Bank of India appear to be converging on introducing a new kind of architecture for formulating monetary policy in India: Parliamentary supervision of inflation targeting. Under this new system, Parliament will set tolerable limits of inflation and the Reserve Bank will maintain the targeted level with the monetary policy instruments in its armoury. An Expert Committee has also recommended the creation of a monetary policy committee, with the governor at its helm. But policy formulation should be done through a process of voting by the members of the committee. 

The new architecture for formulating monetary policy, anchored to inflation targeting by the legislature, is an improvement from the present system. Currently, monetary policy is shrouded in secrecy. It is put together by a small group largely within the RBI, with some outside representatives, but the policy is primarily decided by the RBI governor. The process is opaque. Deliberations by a committee with voting can bring transparency and wider consultations. 

A slew of committees and expert groups have recommended changing the policymaking framework. An RBI Expert Committee on Monetary Policy Framework as well as the Financial Sector Legislative Reforms Commission, have examined this issue. Three guiding principles behind any such change are: defining clear objectives, spelling out an operating framework and lastly operational independence of the central bank to achieve the objective.

On the face of it, the proposed new system meets these requirements. The objective of monetary policy is inflation management through the newly constituted monetary policy committee. And when the legislature gives a target, the RBI has the authority to pursue it.

So far so good. But the underlying assumption is that the Reserve Bank, besides being the sole arbiter, has the instruments for inflation control. The Expert Committee has suggested eventually using the unified instrument for fighting inflation — interest rate — both in the short and long terms. But is interest rate the sole inflation control instrument? We have recently seen how despite the vigorous use of interest rate as a tool, inflation has proved to be defiant. During the tenure of the last governor, D Subbarao, interest rates were hiked for 13 consecutive review cycles, driving up the inflation rate.

Without tending to supply-side issues, curbing inflation could indeed be difficult. Consider the repeated hikes in minimum support price for food grains by Parliament. Can these be inflation neutral? In consonance with increased demand, prices of vegetables and potato and onions had gone up. Interest rate hike, even when it discourages inflationary expectations, can yet be accompanied by price rise just because of physical shortages.

Details and technicalities apart, the spirit of the new architecture is to cast the net wide. Holding stable price line is critical. If the legislators are involved in specifically indicating the tolerable level of inflation, there are two good offshoots: first, reduction in the possibility of acrimonious battles between the political establishment and the monetary authority. Recall the war of words between the finance minister and the governor of RBI over inflation management during the tenure of the last incumbents of both these offices. P Chidambaram and Subbarao had traded charges of intransigence. 

Second, political endorsement of inflation targeting may drive politicians to play their part responsibly. Let us admit, inflation in India is not merely a monetary phenomenon. Politicians may be more amenable to moderating hikes in MSPs, limiting fiscal deficits by rationalising subsidies.