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The decision to hold policy rates, in the face of intense pressure from the finance ministry and industry, is likely to be unpopular with some sections of this country’s political and business elite. But actions of the central bank, as RBI governor Rajan has pointed out in the past, “will not be popular. The governorship of the central bank is not meant to win Facebook likes.”
With the political class often trying to influence their decisions, maintaining central bank independence is a challenge. Politicians, guided by short-term considerations to please their electorate, often end up ignoring the long-term ramifications of their actions, which central bankers have to be mindful of.
The independence of central bankers is contested across the world. The Bank of China isn’t politically independent. Brazil’s central bank chooses an inflation target jointly with the government. In Japan, Prime Minister Shinzo Abe has exerted pressure on the Bank of Japan to print money to get the economy going.
In India, according to the 1934 RBI Act, governments have the power to issue policy directions. But while past central bankers have managed to retain a degree of operational autonomy, in their 2013 study on global central banks’ transparency and independence, N. Nergiz and Barry Eichengreen have ranked RBI as one of the least independent central banks. According to the authors, the manner in which governors are appointed and the lack of independence in policy formulation are some of the reasons for the low score.
Economists like Eswar Prasad argue that central banks in developing countries attempt to limit politicians’ influence by adopting inflation targets for their monetary policy. With monetary policy explicitly guided by these targets it reduces the interference from the political class. In the Indian context, one of the first initiatives undertaken by Rajan was to move towards an inflation targeting regime. Consistent with his past arguments that “focusing on a single objective – low and stable inflation is ultimately the best way that monetary policy can promote macroeconomic and financial stability”, monetary policy is now guided by meeting the inflation target of 6 per cent by January 2016 that Rajan has explicitly laid out. By moving towards an inflation targeting regime, Rajan is clearly transitioning towards a regime that gives the central bank its independence.
The case for a loose monetary policy is largely based on the superficial view that inflation is now firmly under control and that high interest rates are holding back investment. Further, with the government expected to cut its expenditure sharply in the coming quarters to meet its fiscal deficit target, lower rates, the argument goes, would propel private investment which would boost growth.
But rather than succumbing to pressure, Rajan has wisely opted to maintain a status quo on monetary policy, choosing to wait for conclusive evidence that inflation is firmly under control. The monetary policy statement clearly states that the “favourable base effect that is driving down headline inflation will likely dissipate and inflation for December (data release in mid-January) may well rise above current levels” and that “it is reasonable to expect some firming up of these prices (of food) in view of the monsoon’s performance so far and the shortfall estimated for kharif production.” Thus the decision to reverse the current monetary stance is premature.
