Monetary policy in India has continued to lurch from one difficult situation to the next. Last Friday, after the market closed, RBI came out with a series of monetary policy decisions even though it was not scheduled to be an MPC date. A stream of interesting reading has appeared on the subject.
On Monday morning, Ila Patnaik wrote an article in Indian Express and there was an edit in IE at the same time. The stock market dropped 5% that day - the RBI announcements were clearly bad news for India. Update (9/4): Former RBI Governor S. Venkitaramanan has written an opinion piece in Hindu Business Line responding to this.
When monetary policy fail to deliver the goods on price stability, politicians are distraught and think of listening to quacks - the UPA has come up with a series of supply side interventions. ET has three good pieces on this by Amit Mitra, Shubhashis Gangopadhyay and Partha Mukhopadhyay.
What do I think?
- I think there is no tradeoff between growth and inflation in the long run. It is perfectly feasible to have stable 3% inflation and 9% growth for a decade. If anything, I think that high inflation and high inflation vol will drive down GDP growth.
- I think the acceleration in the CPI-IW from 3% in 2004 to nearly 7% today is hugely disappointing and that it is very important to obtain stable 3% inflation. With this inflation vol, the long-dated INR bond market is doomed, which has many disturbing consequences for the financing of long-term projects in India - long term projects will be forced to hold low leverage or engage in original sin (i.e. currency mismatch). Update (14/4): Financial Express has an edit on this dimension.
- I think that real rates remain too low to slow down inflation.
- Thus I would be happy with a monetary tightening, if it were done.
- I think it isn't being done. (See my piece What RBI Wants in BS today.)
All in all, it has been an unhappy set of weeks for RBI. As the editorial in Economic Times said on Monday (2nd):
What is more certain is that its latest move has not done anything to enhance its credibility as a central bank. Rather the feeling is of a slightly panicky monetary authority that is not quite sure how to handle the situation; a view that is bolstered by its conflicting signals on the exchange front.
A day after the bank seemed to have decided to limit its intervention in the forex market, allowing the rupee to appreciate to an eight-year high, it was back in strength. The rupee promptly lost 70 paise in a day. Not all Germans believe in God, but they all believe in the Bundesbank, said former European Commission President Jacques Delors. After the latest move, it will be a some time before we say anything similar about the RBI.
To think effectively about the situation, it is important to think that RBI is a set of high IQ people with considerable competence. Let's be neoclassicals and always attribute intelligence and drive. So it behooves us to ask: What are they maximising?
Central banks are not autonomous creatures that run monetary policy based on their own views. They are agents of Parliament. The RBI Act of 1934 is the contract under which Parliament has outsourced the task of doing monetary policy to RBI. RBI is the agent, and Parliament is the principal. In this setting, much insight is obtained by thinking about the principal-agent problems. What are the agency conflicts of the present contractual structure? How can these agency conflicts be eliminated?
As of today, this contract is poorly drafted. If you ask RBI "Why did you not contain inflation?", it can give you numerous plausible replies. He can say it was because you burdened him with bond issuance for the government (low interest rates were required to subsidise bond issuance), or banking regulation (low interest rates were required to protect banks), or currency objectives (low interest rates were required to deter capital flows).
If RBI's conduct is confusing, it's because the outsourcing contract is poorly drafted. It leaves RBI with tremendous leeway to exercise its own discretion on choosing what monetary policy ought to do, and it leads to a loss of accountability - when you are expected to do two things, you are free to do neither because you always have an excuse.
Hence, I have repeatedly argued that the need of the hour is a redrafting of the outsourcing agreement, to achieve a simple framework where there is complete clarity on what RBI has to do. This redrafting of the RBI Act needs to bring in a framework of transparency, accountability, independence and focus. Better contracting between government and entities outside government is being done in many fields - e.g. CEOs of PSU banks will get bonuses when they do well. RBI will change its behaviour when the governor gets a bonus based on how well he achieves an inflation target.
It is fashionable to criticise RBI these days. The real problem lies not with RBI but with Parliament and the Ministry of Finance. The Ministry of Finance has not woken up to the dangers of running monetary policy in the India of 2007 based on a 1934 outsourcing contract that is ultimately animated by policy thinking over 1913-1926.
Update (6/4): Jamal Mecklai has a great piece in Business Standard on the subject of RBI reforms and the monetary policy regime. And (10/4), Suman Bery summarises recent discussions and suggests that greater exchange rate flexibility is the key. Update (11/4): an editorial on these debates in Mint.