Steady rate and the MPC

He cited higher upside risks to “inflation trajectory”, but said that the Central bank will remain accommodative based on the data it receives. Rajan retained the short-term lending rate (repo rate) at 6.5 percent and the cash reserve ratio (CRR) at 4 percent.

 To the uninitiated, repo rate is the rate at which the Central bank lends money to commercial banks. CRR refers to a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves with the Central bank. Despite pressure from corporate houses and certain sections of the ruling party, Rajan has decided to hold firm and not reduce the repo rate.

 After taking over as RBI Governor in September 2013, Rajan had raised the short-term lending rate from 7.25 percent to 8 percent and retained a high rate throughout 2014. This was because when he assumed office, the retail inflation measured by the Consumer Price Index stood at a worrying 9.52 percent. He began the process of lowering the rates in January 2015 only after inflation began to subside. Since then, he has cut them by 1.50 percent to 6.5 percent. 

Rajan’s decision to not reduce lending rates was because retail inflation had accelerated to 5.39 percent in April 2016 from 4.83 percent the previous month. This sudden acceleration in inflation was due to a spike in food inflation as prices of pulses and sugar rose. A lower interest rate often fuels inflation as consumer demand goes up, which further drives up the prices. 

"The inflation surprise in the April reading makes the future trajectory of inflation somewhat more uncertain...rising crude prices and implementation of the seventh pay commission awards being the key risks," Rajan said in the second bimonthly monetary policy for the current fiscal. 

"Incoming data since the April policy announcement show a sharper-than-anticipated upsurge in inflationary pressures emanating from a number of food items (beyond seasonal effects), as well as a reversal in commodity prices," Rajan said, while explaining his rationale for keeping the rates unchanged. Global demand is still sluggish, crude oil prices are rising once again and the seventh pay commission is going to put more money in the hands of consumers.

 Thus, the chances of rising inflation are indeed high. Rajan is right in keeping the rates unchanged. Caution before misguided optimism always bodes well for a developing economy. The RBI Governor also addressed concerns about bad loans in public sector banks which have lead to a slow transmission of previous rate cuts in the economy.

 In response, he said that the RBI was working to clean up balance sheets as well as ensuring that banks were actually transmitting its policy decisions. Besides basic lessons in monetary policy, the other significance of Tuesday’s announcement is that it could be Rajan’s last solo policy statement before the government sets up a monetary policy committee (MPC). The next policy review will be in August, by which time the new MPC comes into force after the Centre passed the Finance Act earlier this year. 

As per media reports, the MPC’s sole task will be to decide the rates at which the central banks lend. In other words, target inflation. Until this year, the rate was decided solely by the governor in consultation with a technical advisory panel within the RBI.  The new MPC will include three members from the RBI—the governor, deputy governor and another central bank nominee—as well as three members nominated by the government. It is imperative to note here that the RBI governor will not have veto powers. But he will have a casting vote in the event of a tie.

 One must also remember that the formulation of the MPC was the subject of a turf war between the RBI and Centre. Last year, in its revised draft of the Indian Financial Code (IFC), the Centre proposed that the MPC would have four representatives of the government and only three from the central bank, including the ‘RBI Chairperson’—a move that would effectively transfer the RBI’s powers to the Ministry of Finance. The news obviously rang alarm bells among many long-time observers, especially since Rajan has consistently pursued a fiercely independent policy stance. 

The ministry’s revised draft of the IFC had clearly sought to undermine the financial independence of the central bank—an institution that has constantly shielded the economy from volatility in global markets. If the Centre had its way completely, we would have found ourselves with an MPC that would toe the government line. The implications of such a scenario would have been very serious. In the past, the Centre, under both the current NDA and previous UPA dispensation, and the central bank have been at loggerheads over the desired monetary policy outcome. 

As an impeccable institution, with a proven track record, the RBI has formulated the nation’s monetary policy, keeping in the mind the long-term implications its decision will have on the economy, regardless of the government’s whims and fancies. Fortunately, in this mini turf war, the RBI Governor seemed to have his way.

Nonetheless, there is another side to this debate. As per the RBI Act of 1934, all 21 members of the central board of directors, including the governor himself, are appointed by the Government of India. One interpretation of the existing law clearly stipulates that the government can dictate policy to the central bank, which the RBI Governor will be obliged to follow. 

Therefore, any apparent independence that the RBI may enjoy is clearly dependent on how its Governor responds to political pressure. Under Rajan, the RBI has admittedly shown a great deal of independence from political and corporate pressures.  However, certain experts have argued that such a model, where the RBI governor is the sole arbitrator of a nation’s monetary policy, would not leave the institution in good health. 

What if the next governor did not possess Rajan’s courage of conviction? As the sole arbitrator of monetary policy, such a governor would constantly be under pressure to toe the government’s line at the expense of public interest. The assumption that all four (now three) government-appointed members will be the lackeys of the government is misguided. 

The case in point, ironically, is current RBI Governor Raghuram Rajan, who is, for all intents and purposes, someone appointed by the government. Under the revised MPC, the RBI will have to at least consult the government before a final decision is taken on lending rates.