How India Can Bust Inflation
This was a good week for Reserve Bank of India Governor Raghuram Rajan. Euromoney named him the world's best central banker. More importantly, new data showed India's wholesale inflation slowing to its lowest rate in five years. The numbers may give Rajan room to consider a rate cut in the next few months. They should also spur both him and the government of new Prime Minister Narendra Modi to sort out once and for all lingering questions about how India should combat inflation.
In principle, both Rajan and Finance Minister Arun Jaitley support a modern monetary policy framework for the RBI with clear definitions of goals and instruments. Currently the bank maintains three objectives, with priority assigned to none: price stability, financial stability and ensuring adequate flow of credit to maintain growth.
Both sides seem to appreciate that the first goal must take precedence. India's political economy has been traditionally inflation-averse. Rising prices hurt the middle class and poor, the very people who determine which party rules India. The previous Congress Party-led government ignored this cardinal rule and was routed in May's general elections; double-digit inflation was a major cause. Modi's government, which doesn't want to make the same mistake, says it supports making inflation targeting the RBI's first priority.
In a report compiled by its top economist, the bank suggested an inflation target of 4 percent as measured by the Consumer Price Index. (Until now, the RBI's key measure of inflation has been wholesale prices, which are more unreliable and less indicative of the reality felt by most Indians.) The government believes that in a democracy, elected officials rather than appointed technocrats should set the target rate. That's a valid argument, as long as officials don't pick moving targets that change year-to-year. The central bank must retain the autonomy to achieve the target however it thinks best.
Then there's the question of how interest rates are set. At the moment, the process is opaque. Authority to do so rests in a single individual: Rajan. He is not required to explain his actions to the prime minister, parliament or the public.
That needs to change. If India is to establish a modern monetary policy framework, the country needs a multi-member Monetary Policy Committee, like the U.S. Federal Reserve's Open Market Committee. The debate largely revolves around who will sit on the committee, how many members will be appointed by the central bank versus the Finance Ministry, and whether the governor should have a veto.
To balance the need for independence with the need for accountability, the best combination would involve an equal number of members selected by the government and by the bank, with the bank's governor casting the deciding vote in case of a tie. As in the U.S. and U.K., the governor should also have to testify before the legislature on a regular basis.
Finally, officials need to settle on a single instrument for achieving their inflation targets. The RBI currently employs multiple instruments: the repurchase rate, the cash reserve ratio (the percentage of every bank's cash reserves that must lie with the central bank at all times), the statutory liquidity ratio (the percentage of bank assets that must be held in liquid assets like gold and government securities), and others. Ideally, it should use just the first.
The good news is that there are more grounds for convergence than divergence between Rajan's views and Modi's. The uncertainty caused by rampant inflation is the biggest dampener to growth in an emerging economy like India. To fight it, the two men should use this reprieve to unite behind a single, clear strategy.
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