Monetary policy and interest rates

In effect, we have a ‘caged’ monetary policy. Top echelons in the government pre-empt any maneuverability available to the RBI governor, by explicitly stating the direction and extent of relaxation in monetary policy. The finance minister, through a supportive fiscal policy should prepare a fertile ground for the monetary policy to fructify

Prem Shankar Jha, a veteran journalist, writing in a mainstream newspaper on the Reserve Bank of India’s (RBI) monetary policy responsibility, made the following concluding observations:

“The government has done a great deal to assuage the RBI’s legitimate fear of a huge fiscal deficit, and should commit itself to doing even more in the coming months. But the RBI must take its assurances on trust, for it can make the next cuts only after industry and employment begin to grow and spending power starts to rise once more. Dr Manmohan Singh needs to make this clear to the RBI governor and remind him forcefully, as he reminded his predecessor YV Reddy when the latter was reluctant to bring down interest rates even after the onset of global recession in August 2008, that when push comes to shove it is the RBI governor who holds his post at the government’s pleasure and not the other way round.”

This is not the first time a newspaper article goes out of the way to provide scaffolding for an otherwise weak government. Here the difference is, all the five online comments on the article (published on 22nd October) recorded in the next 24 hours of publication were highly critical of the writer’s approach. I too made a brief observation asunder:
“Excellent concluding words for an excellently argued article to salvage the prestige of a government which is struggling with its numbers in parliament, rather than problems staring at industry and the common man. Let us read again: ‘…that when push comes to shove it is the RBI governor who holds his post at the government’s pleasure and not the other way round.’ This will definitely shake up Dr Subbarao who may run to Delhi to apologise for whatever he has done since he took over as RBI governor and will definitely take a dictation of what he should announce on 30th October, if Delhi doesn’t ask him to make the announcement earlier!”

The introduction to the monetary policy statement presented this year by RBI Governor Dr Subbarao is worth a recap:

“This Annual Policy for 2012-13 is set in a challenging macro-economic environment. At the global level, concerns about a crisis have abated somewhat since the Third Quarter Review (TQR) in January 2012. The US economy continues to show signs of modest recovery. Large scale liquidity infusions by the European Central Bank (ECB) have significantly reduced stress in the global financial markets. However, recent developments, for example in Spain, indicate that the Euro area sovereign debt problem will continue to weigh on the global economy. Growth risks have emerged in emerging and developing economies (EDEs). And, amidst all these, crude oil prices have risen by about 10% since January and show signs of persisting at current levels.

Domestically, the state of the economy is a matter of growing concern. Though inflation has moderated in recent months, it remains sticky and above the tolerance level, even as growth has slowed. Significantly, these trends are occurring in a situation in which concerns over the fiscal deficit, the current account deficit and deteriorating asset quality loom large. In this context, the challenge for monetary policy is to maintain its vigil on controlling inflation while being sensitive to risks to growth and other vulnerabilities.”

In effect, we have a ‘caged’ monetary policy. Top echelons in the government, by habit, pre-empt any maneuverability available to the RBI Governor, by explicitly stating the direction and extent of relaxation in monetary policy, well before the announcement. The finance minister, through a supportive fiscal policy should prepare a fertile ground for the monetary policy to fructify. Independent of fiscal policy, the RBI will not be able to achieve any perceivable results. Last two years, we have seen the helplessness of the central bank.   

It is time our political bosses started looking at grass-root level improvements in availability of basic necessities and comforts. To start with, perhaps, the government can follow the example of present RBI governor, who speaks out his problems and constraints in the open, explains what he can do and is doing, almost at monthly intervals and reviews and audits the progress made in the financial sector as a result of policy interventions on an ongoing basis. He also doesn’t mince words when it comes to the expectations of the central bank from those responsible for evolving and implementing fiscal policy.

In fact, the base interest rate hikes whenever resorted to in the recent past, betrayed the helplessness of a central bank which is not getting the necessary backing from the Centre in terms of prudent fiscal policy management. One remembers that last year, while airing his policy concerns specifically about managing inflation, RBI Governor Dr Subbarao had stressed the need for synchronization between monetary and fiscal policies. He also mentioned that in a poor country like India, the RBI has many responsibilities as well and it is not proper for it to focus only on inflation. This plain-speak should have been seen as an expression of his expectations about supportive measures from those in charge of the fiscal policy and an indirect admission of the limitations of the central bank’s policy intermediation in an environment influenced by external compulsions. This, for obvious reasons, did not happen, as the Centre is itself helplessly tied up in the cobwebs of coalition politics.

The change of the finance minister has almost silenced Dr Subbarao, who otherwise is known for his skills of communication and the way in which he articulates his concerns about the status of the economy and his expectations from the GOI. The present fierce stand being taken by the FM, which gets support from a section of business and industry stakeholders, will make it tougher and tougher to manage inflation by rate modulations or liquidity management in future. Let us be warned that it will be disastrous to allow the Indian financial sector to slip back to the interest rates regime that prevailed during the pre-reform days.

The transparency in the central bank’s policy statements gradually introduced during the last two decades and almost perfected by the present governor has made the job of economists to analyse their content and explain to us where things are going wrong somewhat easy. The problem that remains is that those in charge of fiscal policy have other preoccupations and are not in a mood to listen to the ‘laments’ from Mint Road or the sound advice from the economists. This makes it possible to understand the flaws in policy and the possible consequences of the slow pace at which the impact of interventions by the RBI may be felt at the ground level, in the absence of adequate fiscal policy support. To strengthen the central bank and to bring compatibility between fiscal and monetary policy, there is need to speed up review and revision of the RBI Act envisaged in the preamble of the Act itself (The preamble said: “But Whereas it is expedient to make temporary provision on the basis of the existing monetary system, and to leave the question of the monetary standard best suited to India to be considered when the international monetary position has become sufficiently clear and stable to make it possible to frame permanent measures…”). This issue deserves to be taken more seriously by the GOI. Several initiatives taken by the Reserve Bank in this direction have not been successful in the past.

Till such time the compulsions of coalition politics keep them in a tight spot, the next best option before the North Block is to respect and keep in tact the traditions in the relationships between the RBI and GOI built up and evolved through the efforts of eminent governors and efficient FMs during the second half of last century.

Beyond the mandated responsibilities of a central bank, the RBI has been instrumental in bringing about improvements in the areas of institution building in the financial sector, financial inclusion, gold and wealth management (as part of its forex reserve management), revival of grass-root rural financial institutions like cooperatives and balanced economic development across regions by ensuring an appropriate realignment of the outreach of institutional infrastructure using financial sector reforms as a tool. Any move to weaken the RBI, by enforcing ‘ownership’ rights by the GOI or pressurizing the institution to deviate from its well-founded policy perspectives using external compulsions will be detrimental to the health of the financial sector and therefore impair economic development.

(MG Warrier is a former general manager of RBI. He can be contacted at [email protected])

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