Rate cuts and 'pliant' governors

Two successive rate cuts from the RBI in February and April were not an election gift to the government

Some comments are unwarranted, a reflection of naïve acumen and narrow understanding of the subject. One such comment is in the April 13 issue of The Economist magazine that goes like this: “The Indian government has replaced a capable central-bank chief with a pliant insider who has cut rates ahead of an election”. Such sweeping statements are oblivious of ground realities and are based on errant data. 

As we may be aware, the Reserve Bank of India (RBI) has cut rates successively in February and April. These last two rate cuts were undertaken against the backdrop of “pliant macroeconomic conditions” in terms of benign inflation and rising concerns about slowing growth, not because of a “pliant” governor. It reflected proactive decision-making taken by the Monetary Policy Committee (MPC) (of which the governor is a member) based on hard data-driven evidence. The decision has nothing to do with Indian elections. 

Illustration by Binay Sinha

What does the data say? Average Consumer Price Index (CPI) inflation in FY19 was 3.4 per cent (five year average from FY15 to FY19 was 4.5 per cent). Rural CPI inflation was even lower at 3 per cent in FY19 (five-year average at 4.7 per cent). Average food inflation was 0.7 per cent (five-year average at 3.8 per cent) and vegetables prices contracted by 4.4 per cent (five-year average at 1.4 per cent) in FY19. The last time we had an inflation number more than 5 per cent was in January 2018. Average core CPI (a proxy for demand in the economy) was at 5.8 per cent in FY19 (five-year average was at 5.1 per cent). The RBI incidentally had increased the rates in June and August 2018, citing core inflationary pressures. Clearly, if we go by inflation numbers, the decision to cut rates was purely data driven. In fact, a contrarian view that the market currently possesses is that the rates could have been even lower than what they are currently given that inflation has been consistently undershooting in India. 

To us, a larger debate is the issue of central bank independence, with reference to India, but not in the overtly biased manner it has been espoused in The Economist. 

Central bank independence generally relates to three areas, namely personnel matters; financial aspects; and conduct of policy. Personnel independence refers to the extent to which the government distances itself from appointments, term of office and dismissal procedures of top central bank officials and the governing board. It also includes the extent and nature of representation of the government in the governing body of the central bank. 

Financial independence relates to the freedom of the central bank to decide the extent to which government expenditure is either directly or indirectly financed via central bank credits. Direct or automatic access of government to central bank credits would naturally imply that monetary policy is subordinate to fiscal policy. 

Policy independence of central banks refers to goal independence and instrument independence. Goal independence refers to a situation where the central bank itself can choose the policy priorities for stabilising output or prices at any given point of time, thus setting the goal of monetary policy. Instrument independence implies that the central bank is only free to choose the means / interest rate to achieve the objective set by the government. 

Let us examine these issues one by one in the Indian context. The RBI had a long and illustrious history, with 66 per cent of the governors being chosen from the Indian Administrative Service. Some of the past governors (with an IAS background ) managed to create a wonderful aura around themselves that is visible even today. Thus, what is important in running an institution is the understanding of ground realities, and hence appointments are mostly ownership-neutral. 

Second, in the case of India, the RBI has goal independence as the inflation target, though set by the Finance Ministry (currently 4 per cent + 2 per cent), was actually an input provided by the RBI. The RBI also has instrument independence as the repo rate is decided by the MPC only through voting. Globally, most central banks including the Federal Reserve Bank and the European Central Bank have full instrument independence, but not goal. In effect, the RBI is perhaps the only central bank to have both. 

Regrading the third point, it is true that in the Indian context fiscal policy used to override monetary policy. However, beginning 1998, the RBI has stopped printing money to finance deficit of the government (monetisation of the deficit). Since then, the RBI has also stopped participating in the auctions of government papers. However, to be brutally honest, credibility of fiscal policy in India still remains a big issue. 

The problem with central banking post 2008 crisis is that persistently low interest rates with easy monetary policy have pushed up asset prices, enriching the rich and pushed down return on savings, possibly hurting pensioners and households who are not rich but rely on interest income on bank savings. This has meant political considerations have inadvertently played a role in central banking.   

Interestingly, detractors of central bank’s autonomy often argue that an independent central bank lacks democratic legitimacy. Curiously, such detractors derive strength from Nobel laureate Milton Friedman’s statement that money is too important an issue to be left to the whims of central bankers. In this context, heavens will not fall if the RBI and the government move in sync through a consultative process. After all, growth has been specifically mentioned along with inflation in the revised preamble to the RBI Act. 

With the clamour for a rate cut in June gaining momentum given the faltering growth and weak inflation, will The Economist now interpret any further cut as a post-election gift for the new government? Will be curious to know. 

The writer is Group Chief Economic Advisor, SBI. Views are personal