Whose monetary policy?

Indian Express, 5th August 2013

It should be left to an independent central bank with a clear brief and instruments

Indian monetary policy law, like that of many advanced and most emerging economies, needs to define the objectives of monetary policy. The sudden shift away from inflation and growth to a defence of the rupee has caused a lot of confusion. In addition, the law needs to lay down the instruments of monetary policy. This could be the repo rate or any other chosen rate. Once this is done, the RBI needs to be made accountable and given independence in order to achieve these objectives.

Today, even if the government achieves Rs 60 to the US dollar, the cost of defending the rupee is too high. Beyond the tangle that the RBI is now in, these events point to the larger question of monetary policymaking in India. Decisionmaking on monetary policy in India will become increasingly difficult in the next two years. The US Fed will stop easing and US interest rates will rise. If the RBI leaves interest rates in India unchanged, Indian assets will become relatively unattractive. This will put pressure on the rupee to depreciate. If the RBI increases interest rates to prevent this from happening, growth in India will suffer. If it lowers rates, there could be additional pressure on the rupee. There may be episodes of high exchange-rate volatility, such as when the Fed announces the date of reducing its purchase of treasury bills, buys less bonds, stops them altogether, or when it starts reducing the size of its balance sheet.

It is well understood by now that once the capital account is open, a country has to choose between pegging the exchange rate and pursuing an independent monetary policy. The impossible trinity tells us that with an open capital account you cannot have both a pegged exchange rate and monetary policy independence. If the business cycles of the Indian economy were perfectly aligned with those of the US, there would be no problem. But if the US is going to raise rates, we have to make a choice: let the rupee be flexible or peg the rupee to the dollar and tighten along with the US. The middle paths that we try to follow are fundamentally problematic and may only have some limited, short-term impact. Meddling with the exchange rate can only be done by distorting monetary policy, and anyone who says otherwise is trying to obfuscate matters.

As the experience of the last couple of weeks shows us, decisions about monetary policy are not straightforward. First, there is no answer to what the correct level of the currency or interest rate should be. Countries witness deviations of the real effective exchange rate from the historical neutral level. This could be because the real effective exchange rate is not always the market equilibrium, as financial markets are influenced by many forces, or it could be that fundamentals, such as changes in productivity, are pushing it to a new value. Whatever the case may be, manipulating the real effective exchange rate to keep it constant or at the correct level, after accounting for productivity changes, at all times, is an impossible task.

Second, whether a currency should strengthen or weaken to stabilise the economy depends on what phase of the business cycle the country is in. When the economy is slowing down, a weaker rupee will help it recover, when it is overheating, a stronger rupee will help prevent inflation from rising.

Third, any policy action will have an effect not just on the currency but also on interest rates, growth, the fiscal deficit, the current account deficit, business sentiment and investment. There are costs and benefits. Both need to be considered.

These issues suggest that monetary policy actions should be made after thorough analysis, discussion and considering different points of view. Knee-jerk reactions that focus only on one element of the impact of those policy changes are bound to be troublesome. Since governments often come under political pressure to do something, if the job of making monetary policy can be influenced by the government, it results in macro-economic mismanagement. It was an understanding of these difficulties in monetary policymaking, after many episodes of painful mismanagement that led to years of inflation, recession, stagflation and largescale unemployment, that led advanced economies to hand over the task to central banks. They were given independence from the government and required to have structures such as monetary policy committees, which allowed informed decisions and a diversity of views.

Why do governments prefer such arrangements? Why do they allow central banks to be independent and pursue policies that are so important for the whole economy? One reason is the shift in responsibility, particularly for all the costs. Remember that there will always be some losers and some winners from any policy decision. In other words, there will always be voices that say that a decision was wrong and point to the losses it creates. Once the public accepts that it is the central bank that makes these decisions, the impact of criticism of the government for inflation or for depreciation or appreciation is limited.

With the Indian economy opening up in the last two decades, the difficulties of monetary policymaking have increased. By now, there have been many government committees which have suggested that it is time for India to move to a modern framework for monetary policymaking. India needs a central bank with independence and accountability, and with a professional monetary policy committee that decides monetary policy actions using well-defined instruments of policy. The latest of such recommendations is by the Financial Sector Legislative Reforms Commission, which has also proposed a draft law. While it may be very tempting for the government to be able to shape monetary policy at a particular point of time, it needs to understand that it will be well served by such a framework.

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