Institutionalising the monetary policy committee

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An abiding characteristic of Indian reforms is continuity. Large changes come in a series of digestible small steps. This may be one reason for the constant criticism that there is no action—steps add up but often go unnoticed.

The monetary policy committee (MPC) is touted as a major change, a departure from this trend. But it is also likely to, in practice, have considerable continuity with the earlier technical advisory committee (TAC). This allows smooth institutional evolution while making use of embedded knowledge. Continuity is a major advantage of an MPC. Overlapping members make it possible for past experience to inform the future, unlike the abrupt regime change that can happen with a new central bank governor who is the only decision maker.

The Reserve Bank of India (RBI) has considerable experience with a committee advising it on monetary policy. This is likely to be used to devise procedures for the new committee. There will be similar preparation and sharing of information followed by discussion leading to a decision.

Of course, there will be major changes. Typically, in established MPCs, the process takes three days, unlike the 3 hours it used to take with the TAC. The individuals on the MPC, as voting members, will have to share in the much more intensive internal consultations that must already be taking place. In a transition from listening to persuasion, the RBI governor will have to respond to points made and persuade much more than was earlier the case. The external members, however, are likely to continue to be part-time, not full-time, members. This gives the advantage of an external viewpoint, while increasing the availability of experts.

The voting and forecasts will be in the public domain immediately, and more detailed minutes will follow, probably with a lag. This will influence public discussion and understanding of how the economy works.

Anchoring inflation expectations is a primary aim of inflation targeting, and it is probably the most effective monetary transmission mechanism in the Indian context. Thus, communication from the RBI, to which the MPC will contribute, has a major role. But while the quality of the biannual inflation report is critical, its size and density is a disadvantage. Therefore, forecasts and pithy comments from the rate-setting MPC will be useful. The RBI’s forecasts have tended to exceed actual inflation—they prefer to err on the side of reducing inflation too much, rather than too little. But then the forecasts become less effective in reducing expected inflation.

Markets value transparency, and parse communications to decide the buy/sell strategies that will set in their expected inflation in the determination of various asset prices. However, for the success of inflation targeting in India, it is more important for the message to go to households and firms, to enter the wage agreements they negotiate, and the rental contracts they set.

Food inflation dominates household inflation expectations. In order to contribute more to anchoring this, the Indian MPC should set up a formal mechanism for the government and the RBI to coordinate on this major issue. A non-voting government observer on the MPC should be required to report on the specific supply-side measures taken recently and their expected short- and long-term impact on food prices. Apart from quarterly communication to households, this would be a valuable input in the rate-setting exercise, as well as motivating the government to take and announce more measures. It will also bring home to the government specific healthy ways in which it can influence the policy rate set.

More intensive and extensive discussions in the MPC should help identify critical variables and causal chains that need to be focused on, even as it draws on past learning with the TAC. For this to happen, the quality of the government nominees on the MPC is crucial. Monetary policy is a complex and demanding field. Considerable technical expertise is required to understand nuances, and condense them into simple policy recommendations. The MPC has to command the respect, and withstand the scrutiny, of domestic as well as international markets and analysts.

Although a technocratic decision, monetary policy affects many interests, often in opposing ways. This makes it an intensely political decision. So the only way to have decisions taken in the best national interest, rather than favouring one or the other party, is to have non-political decision makers. This is what makes central bank independence so valuable, since it makes possible insulation from short-term pressures. But accountability to Parliament is also required, since ultimately the central bank is an agent implementing the democratic will. It must be able to explain how its decisions are in the long-term national interest.

But decision makers must not be narrow sector specialists, since they would not then have the broad vision required. For example, a financial sector expert would tend to think more about the impact on this sector, but policy has to be made for the nation as a whole. A well-balanced committee can reduce this risk.

Members must not be doctrinaire ideologues either, else they would tend to neglect data and context in favour of fixed priors. It is necessary to pay careful attention to the data and to special features of the Indian economy, rather than blindly applying preconceptions or concepts honed in or applicable to economies at very different levels. In the US also, monetary policy has begun paying more attention to data, since uncertainties have increased. There is no longer a known steady-state towards which the economy is moving. And such a steady-state is even less likely to exist for an economy like India undergoing a process of catch-up growth. Reform means putting the economy on a fast track for development, not assuming that it is developed already.

(This commentary first appeared in Livemint)