In 2006, Raghuram Rajan, who is now the Governor of the RBI, was asked by the Planning Commission, which at that time was resentful of the then RBI Governor, Y.V. Reddy’s steadfast refusal to agree to some of its more adventurous proposals, to make some recommendations to reform India’s financial sector. The collateral idea was to put the RBI in its place.
Dr Rajan made a number of suggestions, one of which was that the RBI should adopt a policy of single variable (inflation) targeting, rather than the multi-variable targeting approach which Bimal Jalan had introduced when he was Governor during 1997-2003. The RBI dismissed the idea out of hand and the Rajan report was shelved.
But now that Dr Rajan has become the Governor, he has revived his proposal by asking his economics deputy governor, Urjit Patel, to say so in a report on monetary policy. Dr Patel has done as asked.
There is really no way of telling whether or not such an approach works. Nevertheless we can get some kind of an approximation to the likely success of such a policy if we have a completely clear understanding of what monetary policy is all about.
In the final analysis monetary policy is about the price of money, which is denoted by the interest rate. Determining this price – whether it will be high or low and if changed by how much – is what the whole thing is about.
The manner of determining the price, the timing of the intervention, and its quantum etc. can vary but ultimately it is what statisticians call a Bernoulli trial, which means there are only two possible outcomes, namely, either that the price goes up or it goes down. An unchanged price is no policy at all so a third outcome is not possible.
Viewed in this light, should we not ask whether too much is not made of monetary policy which in India impacts less than a quarter of GDP because the rest is in the informal secctor?
Also, it matters little whether the price of money is fixed by a committee as recommended by Patel or, as has been the practice until now, by one man, the RBI Governor.
However, the Committee approach will give the finance ministry a handle to interfere because it will influence the appointment of committee members. That surely must be questioned if the limited efficacy of monetary policy depends on what the government does in fiscal policy.
Also, it must be pointed out that the RBI has had a 5 per cent target rate for inflation for almost a dozen years now. So there is nothing new about the 4-6 per cent range that Patel has suggested.
Finally, inflation in India has now become embedded because of real sector rigidities. So single target or not, the RBI is not going to be able to do much about it.
That’s why it should focus on what it needs to do which is to tell the finance ministry to mind its own business and leave the rest alone.
If it ain’t broke, why fix it?
