By Jatin Bavishi
The 1980’s were remarkable for multiple reasons. One of them was that the Keynesian consensus which had emerged after the Second World War—that government intervention and public expenditures are important—was systematically eroded and replaced by Neoliberalism. This was following events in the previous decade such as the two oil shocks and the dismantling of a fixed exchange rate regime.
Neoliberalism believes in the superiority of the market over government mechanisms. Broadly speaking, governments have two policy measures at their disposal—monetary and fiscal. Since the 1980’s, the former has assumed greater significance over the latter.
As Friedman once said…
This change in consensus brought an intensification in efforts to make the Central Bank—the agency that conducts monetary policy—free from all political intervention. Monetary policy has acquired a lot of importance due to the apparent correlation between ‘money supply’ (the quantum of currency in circulation within an economy) and inflation. To quote one of the greatest economists of the 20th Century Milton Friedman, “Inflation is always and everywhere a monetary phenomenon.”
Although the link between the two is stronger in ‘developed’ capitalist economies, the idea nonetheless has diffused into developing economies as well. However, the sources of inflation in the latter can be much more complex, such as a shortage of food.
The intersection of markets and politics
Historically, central banks have always operated in close synergy with ‘politics’. Markets do not value ethics and equity issues. Due to this, political discretion is seen as an important tool. In the initial years following independence, India witnessed massive overhauls in banking. This included the nationalisation of the State Bank of India in 1955, the nationalisation of 14 private banks in 1969 followed by 6 others in 1980, the institution of compulsory Priority Sector Lending (PSL) norms, new rules for opening branches in rural areas, and other changes.
From the perspective of markets, these are ‘political’ interferences and should be done away with. However, these measures transcend the confines of politics. Indeed, they were performed for a social purpose. Of course, banking can become culpable to political interferences. However, to suggest that markets dominate the latter is a far-fetched conclusion. There are wide grey areas.
What should the RBI’s role be?
India is suffering from split personality when it comes to giving autonomy to the Reserve Bank of India (RBI). On the one hand, it wants the paramount monetary authority to do what it knows best. In other words, it should tweak interest rates to keep them aligned to medium and long-term inflation targets. Presently, it is to keep rates at 4% with a 2% upper and lower band. However, on the other hand, it wants the RBI to cut rates, which would reduce the cost of borrowing for both Greenfield and Brownfield foreign direct investments. This would augment public expenditure and contribute to higher economic growth.
Difficulties due to inflation
In the last bi-monthly policy meeting in June of 2017, the Monetary Policy Committee (MPC) decided to keep the policy rate (repo rates) unchanged at 6.25%. The Statutory Liquidity Ratio (SLR) was cut by 50 basis points to 20%, effective June 24th. The central bank also cut its forecast for consumer price inflation in the first half to 2-3.5% from 4.5%, and to 3.5-4.5% from 5% in the second half. This was determined from long-term expectations and was cited as the reason for maintaining the status quo for repo rates.
Despite this, the Chief Economic Advisor (CEA), Arvind Subramanian told The Economic Times that headline and core inflation has declined sharply. The inflation outlook has been rendered benign by a rising currency, good monsoon, and the capping of oil price increases by structural shifts. He blamed the RBI’s inflation forecasting methodology, saying that the errors have been large and systematically one-sided.
An inherent tension
Clearly, the government favours cutting rates in order to spur growth. Unfortunately, this is not a watertight causality. The urge on the part of Finance Ministry can be understood since the economy grew at 6.1% in the January-March 2017 quarter, which was 1% lower than market expectations. This also put India behind China as the world’s fastest growing economy.
It must be noted that there are various state institutions dedicated to promoting public welfare. However, there are wide and sometimes contradictory divergences between these institutions when it comes to identifying a diagnosis and remedy for any problem. Speaking to The Economic Times, former RBI Governor Y. V. Reddy said,
“If RBI always agrees with the ministry then it is superfluous. If it keeps disagreeing it is obnoxious, you cannot keep disagreeing with government…. So some amount of tension – because [of] the way the system is built and because one has [a] short-term view and [the] other has [a] long-term view- we have to accept”.
The friction between the RBI and Finance Ministry is in itself not new. Regardless, it makes itself clear in the different way each views the optimal strategy to maximise public welfare.
Featured Image Source: Visual Hunt
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