Protecting the central bank’s independence

Mains Paper: 3 | Economy
Prelims level: RBI
Mains level: Protecting RBI’s autonomy

Introduction

•  Reserve Bank of India (RBI) deputy governor Viral Acharya’s A.D. Shroff Memorial Lecture last week was the second occasion within a month when he chose to deliver a strong message.

•  This time, it was on the importance of the central bank’s independence.

• His earlier remarks at the Indian Institute of Technology, Bombay, were focused on the prompt corrective action (PCA) framework.

•  If this is an indication of a shift in the communication strategy, it would be a welcome change.

•  Communication has not been the biggest strength of the present RBI leadership.

The importance of independence

•  The issue is being widely debated globally.

•  US President Donald Trump has often criticized the Federal Reserve for raising interest rates. European Central Bank president Mario Draghi recently raised the issue of the threat to central banks’ independence from governments.

•  The most recent example of what can happen when the government obstructs the central bank is Turkey.

•  Government interference led to significant overheating in the economy and now requires painful adjustments.

Aim of the government

•  The approach of a government and central bank is that the latter is not bound by short-term targets.

•  The government will always want the economy to grow at a faster rate.

•  Iit’s the job of the central bank to have the “punch bowl” removed when the party starts warming up so that the economy remains on a sustainable growth path.

•  Use of its powers of money creation and setting the cost of money for short-term benefits can be disastrous for the economy.

•  Therefore, it is important that central banks have the institutional wherewithal to take independent decisions in order to be able to maintain price and financial stability.

•  It is also in the interest of the government that the central bank is seen as taking independent decisions; sending the right signal here helps maintain macroeconomic stability.

•  In this context, Acharya rightly noted: “Far-sighted government leaders may be able to reap benefits of convincing voters about the importance of investing in macroeconomic stability; for instance, by claiming credit for the long-term nature of financial sector outcomes attained by allowing the central bank autonomy in decision-making and delivery of its core functions.”

Other highlights

•  As Acharya highlighted, it is only after deregulation and reforms in the 1990s that monetary policy in India attained modern features.

•  Over the years, there have been instances of friction between RBI and government, but analysts should not allow such cases to cloud the bigger picture.

•  Successive governments deserve credit for appointing outstanding governors.

•  The present government got the legislation passed to make RBI an inflation targeting central bank with a monetary policy committee (MPC).

•  This is a confidence booster for markets, given that it will be more difficult to influence the decision of a committee.

•  The experience so far of adopting the flexible inflation targeting framework is encouraging.

•  If the MPC manages to keep inflation around the 4% mark in the medium term, it will significantly benefit the economy.

•  It will not only strengthen macroeconomic stability but will also lower borrowing cost with a reduction in inflation risk premium.

Way out

•  The increasingly visible difference of opinion between the government and RBI on different matters is troubling.

•  In such situations, it would be advisable for the government to avoid forcing decisions that could be seen as undermining the central bank.

•  The central bank should also explain its position to the government and public at large so that issues can be debated more widely.

•  The need for better communication cannot be overstated. RBI also needs to assert its autonomy when required.

•  The MPC took the right call by refusing to meet finance ministry officials to discuss interest rate policy last year.

•  It would have set a wrong precedent and would have affected market confidence.

•  RBI has also done well by not diluting the mechanism for resolution of stressed assets and the PCA framework.

Conclusion

•  The central banks will have to work hard to maintain their independence.

•  Since they have become more powerful, and their decisions have wider implications for the public at large, central banks should be prepared to answer more questions.

•  The doubts are being raised in the advanced economies as to why central banks are not able to attain their inflation targets.

•  They will have to constantly explain their position and convince financial markets that what they are doing is right for the economy, especially at a time when the basic premise of conducting monetary policy is being questioned.

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General Studies Pre. Cum Mains Study Materials

Prelims Questions:

Q.1) Which of the following is/are a function of RBI?
1. Banker to government
2. Regulation of foreign exchange
3. Collection and publication of data

Choose the correct option
a) 1 and 2 only
b) 1, 2 and 3 only
c) None of the above
d) 1 and 3 only
Answer: B

Mains Questions:
Q.1) Why RBI need to protect its autonomy as well as independence?