## Wednesday, September 09, 2009

### The scope of central bank independence, and the accountability mechanisms that go with this

I have a column in Financial Express today on the rationale for independence of the central bank, and how this is operationalised in democracies.

1. "When elections are approaching, rates tend to be dropped. This makes households feel a bit happier and more inclined to vote for the incumbent"

Did you really meant this . I mean did you deduce this from empirical reality or is it a copy paste from some theoretical assumption.

With my limited knowledge about Indian conditions, I guess the opposite, that is households being happy when interest rates go up, is a more true representation.

2. Prof. can you write something about the two bills in US congress, HR 1207, the Federal Reserve Transparency Act, and S 604, the Federal Reserve Sunshine Act,which is asking for a full audit of the Fed for the first time.

A writeup from you would be interesting in the light of your argument for an independent central bank.

The question I have is whether such an independent central bank be transparent or should it be given a special satus to remain above the RTI or similar acts.

3. Anonymous above ,

Washington post has written a good editorial on the issue of the new transparency bill and the issue of independence of central bank operations

http://www.washingtonpost.com/wp-dyn/content/article/2009/07/23/AR2009072303004.html

Regards

A Kumar

4. Anonymous#1: This is the thought process across many countries, across an extensive literature. The channel of influence is: central bank surprises households with lower interest rates, helps in achieving more buoyant business cycle conditions, households get happier.

There are many variants to the theme of political influences on monetary policy; this is the standard one.

5. Prof, shah,

I know that such a statement makes sense in countries such as USA where the savings rate is zilch or negative.

My question is whether it is true for indian conditions where the savings rate is as high as 25%.

The point is, relationship between direction of interest rate movement and household happiness is contingent on variables like savings rate. Please put forward your arguments , if otherwise.

When you are writing a column on central bank independence in an indian newspaper, I assume you are writing with the Indian reader in mind .

6. As Milton Friedman said: 'Inflation is always and everywhere a Monetary phenomenon' is there evidence to the contrary in India?
Can we afford to sacrfice the growth (and implicitly employment) for inflation?At what stage of growth do countries decide to target inflation?
Is RBI really independent when fiscal deficit is >10%of GDP and on top of which >75% of Oil is imported under APM? Any accoountability or targets in such a scenario will be relegated to the same dustbin which FRBM has been thrown into.

7. It is quite clear that ever since the start of the financial crisis (lets say since Bear Stearns went down in March '08) even the best performing/transparent/rule based central banks were faced with an extraordinary situation and had to evolve into ultimate liquidity providers/lenders of last resort. Are u suggesting that this function be completely be removed from a central bank? Because by definition such a function is not amenable to the establishment and following rules and being transparent about it.(For example the Fed is now being sued in Federal courts in the US to disclose who it has been lending money to; something it has been hesitant to do given the stigma attached to any borrowing done by an institution directly with the Fed). If a central bank does not do this, who does(a FDIC like institution offering disaster protection?). If a central bank has no choice but to do it, then it is inevitable that it will have a more direct role in the regulation and supervision of financial institutions; something that will surely encroach upon its inflation targeting/monetary policy function. No wonder that there are now calls in the UK to dismantle the FSA and have the BoE back into more regulatory/supervisory functions; with even the Conservative Party talking about abolishing the FSA once they are back in power next year. And we all know that the MFC report drew heavily on the FSA-as regulator-plus-BoE- as- inflation -fighter model, so I am not sure where it will leave this idea as relevant for Mumbai/India once something needs to be changed..

8. Dr. Shah,
Excellent, articulate and well-reasoned post as usual. I agree with the bulk of your arguement. Then, why the comment?
I have one small quibble regarding central bank independence and solutions to remedy lack of accountability through the ballot box (transparency, predictability and inflation targeting). The US seems to have tried this approach with the once-deified Alan Greenspan and his blind faith in the markets and low interest rates. That did not work out well. However, the US is too prosperous and currently too unique a country and such a relatively minor - yes I call it minor- experiment gone wrong does not cause wide-spread distress.
What if we get a Greenspan-like idealogue in India as a RBI governor with one mandate- to target inflation? Should not the RBI be made independent , but also transparent, and mandated with printing money to manage this inflation properly? That is my central question. Thank you as always for your posts!
AVK

9. This is a very interesting post, and the comments are also fantastic to read. I’ll have to have a little re-think about my own contact form on our new website

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