Govt changes rule to make RBI more accountable; Governor will have to explain failure if inflation targets are not met

MUMBAI: If Reserve Bank of India Governor Raghuram Rajan fails to rein in inflation, he will now have to write a letter to the government — just as his counterpart in Bank of England does — explaining why he failed. Chances are it could even be put in the public domain, as is done in other countries, for anyone to figure out whom to blame for rising prices.

The rules of the game have been changed to make the central bank more accountable and usher in ‘inflation targeting’ through a new agreement on ‘monetary policy framework’ signed by the government and central bank.

The agreement was signed on February 20, a week before Finance Minister Arun Jaitley said in his Budget speech that the RBI Act would be amended to pave the way for a monetary policy committee (as is the practice worldwide). The agreement released on Monday, however, makes no mention of the proposed panel.

It is understood that there are differences between RBI and the government over the composition of the committee, which may be set up only after the Act is amended."There is disconnect between the framework agreement and the Budget announcement of a monetary policy committee. Clause 7 (of the agreement), which says that any dispute over interpretation or implementation of this agreement will be resolved through a meeting between the (RBI) governor and the government, is redundant," former RBI governor

Chakravarthi Rangarajan told ET. According to the agreement, RBI "shall be seen to have failed to meet the target if inflation is more than 6% or less than 2% for three consecutive quarters".

If RBI fails to meet the target, it has to submit a report to the government explaining the "reasons for its failure", offer "remedial actions" and give a time frame within which the target would be achieved.

The targets set for RBI are an inflation of below 6% by January 2016, and a band of 6-2% for 2016-17 and subsequent years. According to Rangarajan, inflation targeting does not rule out raising rates when inflation is within the target range, if other conditions, such as an asset price bubble, for example, warrant such action. "While interest rates will be raised if inflation is above the target, it does not mean that rates would not be raised when inflation is below the ceiling," he said.

FUTURE RATE MOVEMENTS

While RBI may throw the rule book at the government if it is pushed to cut interest rates, any move by the central bank to raise rates even when the inflation is within the agreed range may not go down well with the government.

The consumer price indexbased inflation is now at 5.11% and may be within 5.5% by January 2016, but after that RBI would aim for an inflation of 4-.4.5%; that’s when the agreement may be put to test.While ‘inflation targeting’ as a policy had come under attack after the 2008 financial meltdown, Rajan and his deputy Urjit Patel believe that RBI’s primary responsibility is
controlling inflation and lower inflation is a pre-condition to growth.

QUID PRO QUO

Thus, while the new rules are in line with Patel’s recommendations, there could be a quid pro quo: these come at a time New Delhi is planning to curtail RBI’s powers over foreign exchange flows and the government debt management. Also, the policy committee composition suggested by RBI is dramatically different from the one recommended by a panel on legal reforms in the financial sector.

"Whatever could have been done within the law has been done. There will be accountability as well as some autonomy. Whether inflation targeting is right or wrong is debatable," said former RBI deputy governor KC Chakrabarty.

According to Partha Ray, professor, IIM-Calcutta, and a former RBI official, "In the absence of a monetary policy committee, inflation targeting becomes a more difficult task. ‘Inflation target' is a number that concerns the entire nation and this agreement places too much focus on the governor. He will either be remembered in history as a man who killed inflation or has to take the entire blame, perhaps unfairly, for missing the target."

PACE OF RATE CUTS MAY SLOW

Under the agreement, RBI shall publish the operating targets and establish the operating procedure of the policy through which the target will be achieved; and, every six months, RBI will explain the sources of inflation.

Some in the financial market believe the new policy framework could slow down the pace of rate cuts. "Given that the new monetary policy framework gives the central bank the absolute prerogative to set policy rates or otherwise to maintain inflation in the 2%-6% band, it may be operationally difficult for RBI to cut rates aggressively going forward beyond a certain level," said Soumya Kanti Ghosh, chief economic adviser, State Bank of India.