In 2016, the Indian government signed a contract with the Reserve Bank of India (RBI), allowing the latter to account for a numerical inflation target within a band. It was our transition to a flexible inflation targeting regime, seen as a major reform, and a step towards strengthening central bank independence. It was not that the mandate of the RBI was not clearly understood prior to this reform, but that numerical targets and clear responsibility were new. If it failed to fulfill its mandate, it had consequences. It was that the RBI would have to “convince” the government of its failure to control inflation. In fact, the RBI has failed for the past two years, as inflation remained consistently above 6%, the upper end of the band. There are no grace marks in this test. Even 1% outside the band counts as a failure. There are some murmurs that a special inflation mandate was a bad idea and that central bank independence is an idea that is being rejected around the world. Nevertheless, an explanatory letter from the offending side is to be sent from Mint Street to Delhi at the earliest. Alas, neither the Parliament nor the public would be aware of its contents. Why Privacy? In an era when minutes of monetary policy committee meetings and the identities of individuals and how they voted are made public, what is so sensitive about an explanatory paper? It is not as if a non-sense public is being spared the esoteric language and mathematical models that are the approximate content of this paper. Is it because the RBI can revise to understand the real burden of a fiscal overhang that makes its job so difficult? Or that its ‘independence’ has been heavily compromised? RBI has found in recent years that despite using sophisticated models and a powerful ammunition of extensive survey data, apart from the various monetary instruments at its disposal, inflation is not only difficult to control, but also difficult to predict. . RBI has underestimated inflation many times. There are many reasons for this, global and local. India’s inflation is dominated by food and fuel, and the RBI is not the only one to consider itself unequal to this task. Watch central banks around the world as they grapple with post-war record inflation, and now face the blame for acting too late as inflation expectations falter. Look at the extreme price volatility (remember that the West Texas benchmark oil price was briefly $37.6 a barrel in April 2020!). Therefore, the prediction and management of inflation is a complex problem by its very nature. This does not mean that we should not delegate the task of protecting the value of our currency to central banks.
To be able to protect a currency from price erosion, the time horizon of a central bank must be longer than election cycles. It needs time to build credibility. Furthermore, it must be free from political pressure to either engineer a boom just before the election or postpone the pain of a rate-hike so that voters don’t get angry. Hence there is a need for some independence or autonomy. Such autonomy does not mean that there is no accountability.
The need for independence has been a matter of faith for many decades. If the economy is headed for a recession, the central bank should provide some stimulus, but not too much. If the economy is heating up, the bank should brake as soon as possible. But it should not succumb to political pressure or popular mood or financial markets. The then-chairman of the US Federal Reserve Bank of America said that the famous quote that the job of the US Fed is to “remove the punch bowl as a party”, dates from the 1950s. But since the fall of Lehman and more, that adage has been put to serious testing, due to unforeseen events such as the recent Brexit, the pandemic, and the now-endless Ukraine war. We’ve invented terms like “unconventional policies” and quantitative easing, which mean real financial support using a central bank. More than half of all government debt in Japan is owned by the central bank. The Turkish president fired several central bank chiefs for not doing his bidding. In the US, the Fed seems to be bowing to pressure from Washington or Wall Street or both. In India too, the massive fiscal expansion of the last two and a half years has been largely controlled by the RBI. Recently, the Prime Minister of Finland questioned the central banks who are driving the economies into recession because of the imprudence.
Does this mark the end of the era of central bank independence? not enough. How would central banks otherwise protect the currency and repel fiscal (i.e. inflation) threats? You cannot fight inflation by distributing extra money to people. You can’t find a way out of inflation. Former UK Prime Minister Liz Truss discovered the hard way that you can’t just cut taxes and increase spending to help people meet extra energy bills and still keep inflation under control. That ‘mini-budget’ plan had to be scrapped. Expensive politicians should heed the advice of the central bank. But perhaps we are moving into an era of greater monetary and fiscal coordination, or even cooperation. Former RBI governor YV Reddy used to quippily say that RBI has complete autonomy as long as it is in the area surrounded by Delhi. As in Reddy’s time, we may have to go back to an earlier framework of multiple indicators and a multi-pronged framework for monetary policy, inflation management, financial stability and full employment. The load may change, but it will not make the central bank non-transparent. It will remain accountable without posting an explanation letter!
Ajit Ranade is a Pune-based economist
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