Monday, March 02, 2015

Monetary Policy Framework Agreement: The first clarification of what RBI is to do

Our flawed inheritance

The Chamberlain Commission (1914) and the Hilton-Young Commission (1926) led to the drafting of the RBI Act. This was introduced in January 1927 and enacted in March 1934. The RBI Act does not state what the objective of RBI is. The authors of this Act were quite honest about what they were doing:

An Act to constitute a Reserve Bank of India. Whereas it is expedient to constitute a Reserve Bank for India to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in [India] and generally to operate the currency any credit system of the country to its advantage;

And whereas in the present disorganisation of the monetary systems of the world it is not possible to determine what will be suitable as a permanent basis for the Indian monetary system;

But whereas it is expedient to make temporary provision on the basis of the existing monetary system, and to leave the question of the monetary standard best suited to India to be considered when the international monetary position has be come sufficiently clear and stable to make it possible to frame permanent measures.
From 1934 onwards, this `temporary provision' has been India's central bank. In the years of Indian socialism, this flawed beginning ossified into a full central planning system governing finance. Every detail of products and processes in finance is micro-managed. Alongside this, India got high and volatile inflation:

Fiat money made by RBI failed on the prime test: low and stable inflation.

It is easy to criticise RBI. It's like going into a time machine and making fun of what folks did not know in 1934. This is not a criticism of the individuals at RBI today. The problem lies right in the institutional DNA. What we have is not a central bank; it is a central planning agency for finance, with an improbable and conflicted set of objectives. Accountability mechanisms are absent. Good governance principles, and the rule of law, are missing. Even in the hands of good individuals, RBI has lurched from one mistake to another.

Figuring out the solution

I first saw the beginnings of clarifying what RBI was about at RBI. C. Rangarajan and S. S. Tarapore essentially understood that what made sense was a focused inflation targeting RBI + an open capital account. In the 1990s, open economy macroeconomics was not as well understood, and they did not quite get the fact that this inevitably meant a floating exchange rate. But they had intellectual leadership on the idea that low and stable inflation is the dharma of a central bank.

Similarly, in the late 1990s, intellectual leadership on reforming debt management arrangements came from RBI. By the early 2000s, RBI was saying that there is a conflict of interest between the objective of debt management (i.e. to borrow for the government at low rates of interest) and the objective of monetary policy (i.e. to deliver low and stable prices). To do a good job as debt manager would generate interest rates that are too low, and give an inflationary bias. The solution was for the government to find its own debt management arrangements, and unburden RBI of this conflict of interest.

While RBI fought inflation in the 1990s, this ethos did not turn into legal instruments, organisational reform, and lasting institutional change. By the early 2000s, RBI was back into hankering for exchange rate pegging and more capital account restrictions. On debt management, RBI's position shifted to defending turf. Intellectual leadership on RBI reform shifted outside RBI.

By the early 2000s, as the difficulties of exchange rate pegging became visible. RBI's pursuit of exchange rate objectives repeatedly led to the wrong decisions on monetary policy, and gave RBI a bias in favour of preventing the emergence of a capable financial system. When the Agent is given multiple objectives, he is accountable for none. The heart of the problem lay in putting an end to the temporary arrangement: in establishing a clear objective, removing conflicts of interest, and setting up accountability mechanisms.

The earliest sources that I am able to find on the Internet are a newspaper column by Ila Patnaik on 21 August 2006, Inflation targeting: Much ado about something by Deena Khatkhate in the EPW, December 9-15, 2006, and the Percy Mistry report (2007). By 2007, serious people in Indian macro/finance knew where India needed to go: Inflation target + Open capital account + Floating exchange rate. All the other expert committee reports supported this.

The long run answer

The Indian Financial Code, drafted by Justice Srikrishna's commission, is the full, coherent, internally consistent replacement for the menagerie of Indian financial laws. Once this is enacted, the RBI will have clarity of purpose, and will have sound governance. That is for some unstated date in the future. Does this mean that nothing can be done in the short run?

Some progress in the short run

In 1997, the Finance Secretary, Montek Ahluwalia, and the RBI Governor, C. Rangarajan, signed a `Ways and Means Agreement', which put an end to money creation for deficit financing. This was not in the law, but it was a step forward. The agreement, by and large, delivered.

In July 2014, the Budget speech announced that a monetary policy framework would be put into place. Ordinarily, one would think this is a combination of an inflation target and the machinery of an MPC.

Today, MOF has released a Monetary Policy Framework Agreement signed by RBI & MOF.

It establishes an inflation target. That is a good thing.

Oddly enough, there is no Monetary Policy Committee (MPC). The interest rate is decided by one person: the RBI Governor. This will lead to many infirmities. But this is progress, for the period until the IFC is enacted.

Like many of the other things in this year's budget speech, this is halfway there. Ideally, it should have been an inflation target + a properly constructed MPC. There is an odd loss of nerve.


  1. The RBI governor as the sole decider of the interest rate is consistent with the Gibbard-Satterswaithe Theorem. I have pointed this out a few times before in my columns.

  2. Since no links have been provided to the report that forms the basis of RBI Act, 1934, here are some interesting links on the Young Commission's report:

    1. Review of the Report in American Economic Review,

    2. Summary of the useful parts of the report,

  3. If there are three objectives (Inflation target, Open capital account and Floating exchange rate), is it not reasonable to expect 3 independent agencies to be responsible for these 3 objectives in stead of only one (RBI)? Can somebody enlighten me on this?

    1. You need a Ministry of Steel as the administrative price-setting mechanism when there are controls on the price of steel. When the price of steel is not controlled, there is no need for a corresponding bureaucratic machinery.

      Open capital account = no capital account restrictions ==> No requirement for a bureaucratic machinery.

      Floating exchange rate = market exchange rate ==> No requirement for a bureaucratic machinery.

      Capitalism is what people do when you don't tell them what to do.

    2. Each and every organization (private or public) has planning, organizing and controlling functions. Macroeconomic organizations are not exceptions to this.

      Part of planning, most of organizing and small part of controlling functions can be delegated to private sector. Public sector does have roles to play in most of the planning or controlling functions.

      I understand that price setting, which can be admirably performed by the market forces, is only one part of controlling function.

      Libertarianism vs socialism/central planning debate is very narrowly focussed and misses the full picture.

      Steel price example is not a perfect example for this discussion.
      (1) The primary role of RBI is to set the price of money administratively.
      (2) There is still a mechanism needed to provide buffer for forex reserves - to absorb and release forex, as needed.

    3. Under a floating exchange rate, there is no need for reserves.

      You may find this Mythbusting post be of interest.

      Yes, setting the price of money is monetary policy.

  4. What's that saying that says that its better to do nothing than to do something half-heartedly?
    This is the risk today. We are going to go down the path of reforms in a piece-meal, half-hearted fashion and when it doesn't result in the expected outcome because of bad implementation, we are likely to roll back the reforms than to do them correctly. So, it goes. Now, we have to wait for the economy to get weaker, for inflation to go above 6% and then we will see all talk of reform out of the window and back to the same old nonsense.

  5. I am a bit confused here. Being a debt laden economy that we are, how the three aspects of forex, monetary policy and debt management are to be done? While PDMA is in the offing, RBI focuses on inflation targeting who will look at forex management. Is migration to floating exchange rate feasible for Indian system?

    1. Yes, it is perfectly feasible for India to have the market determining prices like steel, cement, petrol, rupee, etc.

    2. Can you please guide me to get grip on principles based on which you assert that it is feasible?

  6. After PDMA, will the regulation of banks and financial systems remain with RBI or be transferred to the new agency?

  7. See the IFC documentation to understand the full financial regulatory architecture and where PDMA fits in it.

  8. "... to leave the question of the monetary standard best suited to India to be considered when the international monetary position has be come sufficiently clear and stable to make it possible to frame permanent measures." I think the context for this line is the long debate on whether India should have a silver standard, a gold standard, a gold exchange standard (which Keynes suggested in his book on Indian Currency and Finance) or a sterling standard. The near collapse of the global financial system after 1929 was perhaps why the RBI Act tried to postpone the decision of what monetary standard should India have. I think these were debates quite distinct from the problem of the objectives of the central bank.

    1. In 1934, it made sense to be cautious, and to setup RBI as a `temporary' measure.

      Unfortunately the outcome of those debates (today's RBI) is not distinct from the problem of the objectives of the central bank. We have a flawed creature in our midst because we're stuck with that temporary action.

  9. can you please explain the conflict of interest b/w debt management and setting up of monetary policy?

    1. The investment banker advises the borrower and figures out all the things that need to be done in order to obtain a low cost of borrowing.

      Monetary policy controls the cost of borrowing in ways that stabilise inflation.

      The two objectives (low inflation vs. low cost of borrowing) are conflicting.

      In addition, if the investment banker to the government also regulates banks, he has an incentive to increase financial repression, so that his job of selling bonds becomes easier.


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