Monetary Policy Committee is just a cosmetic addition, not suited to India

Tackling inflation with monetary policy is like trying to move boulders with eyebrow tweezers

The first Monetary Policy Committee (MPC) has exited. The government and the Reserve Bank of India (RBI) will soon appoint a new MPC.

The MPC makes us look modern or, rather, western. But is it useful as anything more than a cosmetic? I wonder.

The Committee’s main job is to fix the price of the most important thing in the economy: money. It’s called the interest rate.  Earlier it was the RBI governor who did it alone, more-or-less.

One of the side things the Committee does is to ‘target’ a particular rate of inflation. This rate in India is a range between 4-6 percent. The interest rate is fixed accordingly. If inflation is seen as likely to increase, the interest rate is raised so that credit expansion is lowered. And vice versa.

But there are three questions that arise in the Indian context.

The first is whether Indian inflation was ever unstable — which is different from high — except during severe supply shocks. It wasn’t. Moreover, supply shocks can happen even now.

The second is whether it is at all possible to have a pan-Indian rate of inflation when India almost exactly resembles the European Union. They don’t have a single rate there for the whole EU.

The third is whether by calling it targeting you are actually targeting anything other than a particular voting outcome in the MPC. This is the theoretical bit and crucial in understanding whether any committee is truly effective.

On voting in committees there is one thing that everyone agrees on: even in the most democratic of voting systems, in the end, someone has to impose a decision that will be basically dictatorial. If this is not done, good outcomes can rarely be reached. This is the famous Gibbard-Satterthwaite theorem.

Indeed, it is because the RBI used to unconsciously follow this theorem that it had been largely successful with monetary policy. The MPC therefore is just cosmetics.

As to the first question, look up the data. By and large Indian inflation has been very stable. It may spike temporarily but overall in any ten year period it’s been stable and, on the whole, predictable.

Finally, where the second question is concerned, it’s faddish to target a single rate of inflation in India. This is because the only way you can stay within the all-India range is if large parts of India have sustained negative inflation!

So here’s what I believe: in India inflation is a fiscal problem, not a monetary one. In the old days governments would start to worry if the next DA instalment fell due too quickly and/or if a general election was imminent. Money supply and interest rates didn’t come into it.

But after 2002 foreign money started coming into the bond market. To reassure them the RBI set up the Technical Advisory Committee in 2005. It advised, but the governor decided. There was no voting. That system worked well enough. But then came the Rajan-Patel duo and the rest is recent history.

They overlooked the fact that our inflation problems have always been because of excessive government spending and not because of excessive credit expansion to the private sector which, unlike governments, is sensitive to interest rates and monetary policy.

But we are trying to tackle inflation with monetary policy. That’s like using eyebrow tweezers to move boulders.

Twitter: @tca_tca