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Business News/ Opinion / The monetary policy imbroglio
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The monetary policy imbroglio

Monetary policy cannot succeed in India without the creation of a modern fiscal policy framework

Photo: BloombergPremium
Photo: Bloomberg

The new version of the Indian financial code has sparked a firestorm of controversy. Most of the heated debates have been about the attempt to increase government leverage over monetary policy. These are not exactly new worries. I had written in March 2013, soon after the first draft of the new financial law was made public, that the way the proposed monetary policy committee was to be constituted effectively meant that the government would have a greater say in monetary policy.

There is a broad consensus that the onus of monetary policy should be shifted to a committee. The problem is with the institutional details, such as who appoints the committee or how important the governor is in the new scheme of things. Once an inflation target has been set, a greater governmental say in the operational aspects of monetary policy can lead to disturbing consequences.

Consider the following situation. The Reserve Bank of India (RBI) has signed an agreement with the government to keep inflation below a certain level. There is a national election or a big state election coming that the ruling party desperately needs to win. The government then goes on a spending spree to win over voters before the elections.

Such a demand stimulus pushes up inflation above the mandated target. The central bank wants to increase interest rates as a result. The issue is taken to the monetary policy committee for a vote. The committee is dominated by members who have been appointed by the government. They strike down the proposal to increase interest rates. The inflation target is breached.

Now the tricky problem is to determine who has greater incentives to deviate from credible monetary policy: a monetary policy committee member who has been appointed by the government or one who has been appointed by the central bank?

An email exchange with one of the economists who helped draft the financial code led to a agreement that it was a question of individual incentives. He argued that the members appointed by the government would have greater incentives to do the right thing while my belief is that these members would have strong incentives to push what economists call time-inconsistent monetary policy. And there is no doubt that the central bank governor, even though he is appointed by the government, has strong incentives to pursue the inflation goal he has publicly committed himself to.

There is a deeper issue involved: the complicated relationship between monetary policy and fiscal policy. High inflation in India is not exclusively the result of loose monetary policy—irresponsible fiscal policy is also to blame. A lot of the monetary reform after 1985 has tried to reduce fiscal dominance over monetary policy: the decision to move to market-determined yields on government bonds, the end of automatic monetization of fiscal deficits after ad hoc treasury bills were phased out, the decision to keep RBI out of primary gilt auctions, and repeated calls for a cut in the statutory liquidity ratio of banks.

The Indian financial code seeks to reduce fiscal dominance over monetary policy by creating a new Public Debt Management Agency that will handle bond issuance by the government to fund the fiscal deficit, freeing the RBI to pursue its main monetary policy objectives.

But creating a new agency to manage public debt will do little to strike at the root of the fiscal dominance problem.

The upshot: the new monetary policy framework cannot be truly effective unless it is complemented by a new fiscal policy framework.

This column has on several previous occasions argued that India also needs a new fiscal policy framework. Those who habitually castigate RBI for not running monetary policy according to a modern rule book should see that there is an equally crying need for a new fiscal policy rule book.

There are four main components of such a new fiscal policy framework: a new fiscal law that imposes effective limits on deficits; an independent organization like the Congressional Budget Office in the US to provide a proper analysis of the budget numbers; a sharp reduction in the statutory liquidity ratio so that the government does not get easy access to bank deposits to fund its fiscal deficit; and an empowered fiscal council that has a say in designing the budget.

The inflation crisis of 2011-14 hurt the credibility of Indian economic policy. One reason why inflation stayed high was that both the government and the central bank failed to withdraw the stimulus they had introduced in 2009 to deal with the demand collapse after the global financial crisis. But Indian monetary policy has generally been more disciplined than Indian fiscal policy.

And that is why the new monetary policy framework is doomed to run into trouble unless New Delhi is constrained with a new fiscal policy framework.

Niranjan Rajadhyaksha is Executive Editor of Mint.

Comments are welcome at cafeeconomics@livemint.com. To read Niranjan Rajadhyaksha’s previous columns, go to livemint.com/cafeeconomics

Follow Mint Opinion on Twitter at twitter.com/Mint_Opinion

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Published: 28 Jul 2015, 11:25 PM IST
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