Deflated credibility

Indian Express, 19 May 2011

RBI Governor's speech in Basel was made 6 days after the hawkish credit policy announcement for this year. The Governor defined the role of the RBI as it is seen in the RBI Act of 1934, opposed any change in the role and functioning of the RBI despite developments in financial markets, in the Indian economy and in the field of monetary economics since 1934. This speech repeats the flaws of RBI communication of recent years, undermines the impact of the recent monetary policy announcement, and increases the cost that India will have to suffer in bringing inflation under control.

Instead of discussing how the RBI can reinvent itself to address one of the most important questions facing India today, namely inflation, and to help bring about changes in the financial and regulatory architechture of the country that will serve the economy and people best, the Governor's speech is about how RBI has served India well in the past, and should, therefore, not become a central bank which primarily runs monetary policy to deliver low inflation. Along with saying that RBI will be responsible for many other objectives, the Governor emphasised that RBI should not be held responsible for delivering low inflation.

If the central bank does not take responsibility for inflation in the country, who will? It is not a coincidence that all over the world, this function has been carved out from other conflicting functions and given primacy in central banks. The public demands lower inflation. Sooner or later, the excuses provided by central banks about why it cannot be delivered, because of other conflicting objectives, become the very reason why these other objectives are taken away from central banks, and they are charged with the responsbility for low inflation and made accountable for it. In this sense, while Dr. Subbarao's speech is intended to defend the present RBI, it urges the process of RBI reform.

The timing of Dr Subbarao's speech is particularly unfortunate. In the policy announcement on May 3, the Governor pledged that he would fight inflation. Just one week later, on May 9, he has reneged on this promise. He went out of this way to say that RBI is not focused on inflation. The defence of RBI turf has come immediately after a sharp hike in interest rates. Ideally, if the rate hike had to have impact, it should have been followed by a well laid out communication strategy to convince the public that the RBI is now going to focus on inflation. Turf wars about public debt managment, banking regulation and financial stability should have been the last thing to discuss at this time. Inconsistencies between what the Governor said in the credit policy, and his speech a week later will damage RBI's credibility and public perception on its commitment to fighting inflation.

For instance, last week the Governor had said:

"... the conduct of monetary policy will continue to condition and contain perceptions of inflation in the range of 4.0-4.5 per cent"

He now says:

"Monetary Policy, as is well known, is an ineffective instrument for reining in inflation emanating from supply pressures. It is unrealistic, under these circumstances, to expect the Reserve Bank to deliver on an inflation target in the short-term."

Further, the Governor now says:

"We have a problem about which inflation index to target."

These and other arguments, which the governor made in many speeches last year, for RBI not focussing on inflation, are a large part of the reason why despite 8 interest rate hikes, RBI was not able to bring inflationary expectations under control. Every time the Governor raised rates, he then made a speech about how fighting inflation was not his priority.

Commitment to fighting inflation is as important, if not more, than raising interest rates. Unlike the traditional monetary economics such as the quantity theory of money, which most of us were taught in university, it is now well understood that prices do not change in response to changes in demand and supply of money. Inflationary expectations play a crucial role in determining output and inflation. The central bank's monetary policy plays a crucial role in shaping these expectations. If RBI's 50 basis point hike is to mean more than just pain to borrowers, but is going to keep wages and prices from rising, it needs to be translated into a change in the perception of the people who start believing that RBI will no longer accept high inflation and will do all it can to reduce it. If immediately after the rate hike RBI starts making excuses about why it will not deliver, low inflation, why its policy will not work and why it should not even be expected to work, this will undermine the policy action itself. With this speech Dr Subbarao has reducing his chances of controlling inflation.

If the communication strategy is done right, inflation control will be achieved through a smaller set of rate hikes. With such mistakes in communication, the country will have to suffer a much sharper set of rate hikes in order to get inflation back under control.

The role and functions of RBI defined in the 1934 Act may have served India well for many years. But since then India has changed. The needs of the real sector have changed. Financial markets have developed. Rapid globalisation has brought new challenges. The central bank has to keep up with the needs of India today and tomorrow. RBI can either reinvent itself, or over the next few years, when the country forces change, it can oppose the change. To reinvent itself RBI needs a leadership that can provide it with the intellectual framework for change. Dr Subbarao has failed to provide this leadership.

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