The Changing Framework Of Monetary Policy: Fill & Download for Free

Governor Rajan faced significant political pressure in his effort to maintain RBI’s monetary policy independence, which is considered paramount to most modern central banks.Unfortunately, his reluctance to support a highly stimulative monetary policy was viewed unfavorably by fiscal authorities engaged in an aggressive policy to further foster growth, and RBI’s policy independence subsequently came under attack in a effort to induce “policy cooperation.” Governor Rajan, in turn, was perceived as an obstacle.Governor Rajan’s monetary policy viewGovernor Rajan is a pragmatic policymaker who acknowledged limitation in monetary policy - an exceptional view in an era when ultra-easy policy (financial repression) favored by central banks elsewhere have re-opened debate on the once-taboo option of debt-monetization (helicopter money):And here I think there is more of a consensus that monetary policy pretty much has run its course. There are still guys who are looking for helicopter drops of money but I think that is a step sort of too far into the dark, where I am not sure there is a political consensus to do that in the major economies, if it comes to that.Further more, Governor Rajan had touched on a sensitive topic, that ultra-accommodative policy can act as an unnatural clutch to uphold an inefficient system and prevent market forces from making necessary adjustments (i.e. unsustainable institutions are being kept alive by cheap funding). Additionally, Governor Rajan cautioned that fiscal policymakers would grow complacent as aggressive monetary policy easing reduce the urgency to initiate necessary (but sometimes painful) structural reforms:My sense is industrial countries’ central banks should probably consider whether they are doing more harm than good by easing further. I don’t think the benefits beyond a certain point have been that clear, and certainly the costs of staying in this ultra-accommodative phase for much longer will build up – the known costs – and then there are less-known costs. How much are we, with these policies, preventing adjustments that should take place. I know this has got a bad name, it is the “liquidationist” or “Austrian” view, but it is a very real question of whether we’ve allowed the adjustments to take place enough or whether we’re keeping too many inefficient firms alive.Governor Rajan also outlined a framework that explains why low rates may induce the opposite behavior expected by policymakers - and why extreme monetary policy designed to create inflation may actually constrain consumer spending and lead to dis-inflationary outcomes:This is the point that a number of people have been making, which is if I push interest rates below a certain point, the income effects start becoming greater than the substitution effects. The usual point is I push down interest rates – I say, “wow, it is better to consume now than to save,” and I consume. But what if I have an end-of-life goal in terms of savings and I push down interest rates really low and I say “wow, I really can’t meet my savings goal. I am going to be on the streets when I am old, so I better save some more.” That is the perverse effect of low interest rates.Unfortunately, such thesis also raised questions on the efficacy of policies enacted by many central banks in the years following the financial crisis, with damaging implications to a number of institutions’ credibility (namely BOJ and ECB) if Governor Rajan is proven right.Conflict with fiscal authoritiesGovernor Rajan’s cautious view on using low rates to stimulate the economy made him an obstacle to fiscal authorities’ desire to use low rates to boost growth and allow corporations to borrow cheaply:Mr. Rajan’s critics, led by the parliamentarian Subramanian Swamy of the ruling Bharatiya Janata Party, complained that he had focused too much on reducing inflation and had not acted to ease the heavy debt burdens of many Indian companies.Mr. Swamy, a former commerce minister and law minister, was jubilant on Saturday, saying a change in leadership would probably lead to swifter economic growth.“I certainly wanted him out, and I made it clear to the prime minister, as clear as possible,” he said, adding that he expected a positive reaction from India’s industrialists.“His audience was essentially Western, and his audience in India was transplanted westernized society,” he said. “People used to come in delegations to my house to urge me to do something about it.”The public attacks on Mr. Rajan, analysts said, coincided with a growing conviction among Mr. Modi’s inner circle that with inflation under control, the time was ripe to loosen monetary policy and publicly celebrate India’s robust growth.Mr. Rajan was not inclined to do so. In interviews, he continued to urge the government to undertake structural reforms to the banking industry and to warn against complacency.Erosion to RBI’s policy independenceWith the Governor of RBI fighting to maintain policy independence, fiscal policymakers also intensified efforts to exert control. Governor Rajan was behind a push to create a monetary policy committee (similar to Bank of England’s MPC) to formalize monetary policy decisions, and RBI internal panel had initially outlined the following structure:5 members, 3 members selected from within RBI, 2 external members selected by the central bankThe government subsequently suggested an alternative plan:7 members, 4 members appointed by the government, 3 from within RBIThe compromise structure:6 members, 3 members from RBI, 3 members appointed by the government, with RBI Governor casting the tie-breaking voteThe push-and-pull didn’t stop there, as the government extended Deputy Governor HR Khan’s term without consulting with Governor Rajan. It was also recently announced that the cabinet secretary will head an interview panel to select RBI’s new Deputy Governor. This panel had always been headed by the RBI Governor until now.Governor Rajan likely recognized the erosion of RBI’s policy independence, and there are (undesirable) precedents of forced cooperation between fiscal and monetary authorities.Central bank policy independenceMonetary policy independence is often a hard-won outcome far from the path of least resistance.For example, the Federal Reserve was not an independent central bank until the Treasury-Federal Reserve Accord in 1951. Until then, the Federal Reserve had artificially kept interest rates low on behalf of the U.S. Department of Treasury to monetize fiscal expenditure during World War II (by holding both short-term and long-term interest rates artificially low, the government was able to issue low coupon war bonds - buyers of such war bonds subsequently suffered heavy losses in the ensuing high inflation years).Fed’s modern QE programs were relatively more benign compared to the direct debt-monetization during the 40s and 50s, when the FOMC printed money to buy securities to maintain a interest rate caps of 0.375% for Treasury bills and 2.5% for Treasury bonds.Unfortunately, such aggressive policy incurred a heavy toll on the economy - large-scale debt monetization rapidly pushed prices higher, and inflationary pressure became more entrenched. Economists and market participants often highlight then Federal Reserve Chair Paul Volcker’s fight against high inflation, but price instability was a bigger issue during the time when Federal Reserve ceded control of its portfolio and the money stock to fiscal authorities:ConclusionUnlike the Federal Reserve, the RBI is more susceptible to fiscal authority’s demand for policy easing, and erosion to its monetary policy independence can have negative long-term consequences. Governor Rajan had two choices - maintain current path and defend central bank policy independence until the last moment, while clashing with fiscal authority’s bias toward reflationary policies, or announce a return to academia (he is currently on leave from the University of Chicago). He apparently chose the latter.

It's a sad event. Like most sensible Indians, I'm a big fan of Dr Raghuram Rajan. However, there's no need to panic. I was scrolling through my Facebook newsfeed reading status updates of people screaming that without Dr Rajan, the economy is going to the dogs, inflation will skyrocket and our banking system, plagued with elevated levels of bad loans, will collapse. Most people think that the RBI is a one man show, that's not true at all.During his tenure:He diluted the power of the Governor’s chair. Dr Rajan has asked for the creation of a monetary policy committee[1]mandated with the task of guiding interest rates in the economy. It will consist of the six members, three nominated by the RBI and three by an external selection committee. In cast of a tie, the governor will have a casting vote. The monetary policy committee framework will replace the current system where the RBI governor and his internal team have complete control over monetary policy decisions. While a technical advisory committee advises the RBI on monetary policy decisions, the central bank is under no obligation to accept its recommendations. Setting up a monetary policy committee is a standard practice for most of the worlds prominent central banks.He has set up a straight line path to inflation which his successor is highly unlikely to change. Dr Rajan's inflation target of 5% has been difficult to achieve because of rising crude prices and sharp rise of primary food items[2]. If we have a bad monsoon this year, inflation will rise further. I think it's unlikely that the successor will change the inflation target set by Dr Rajan.Who should be the next RBI Governor? My vote goes to SBI boss Arundhati Bhattacharya.World Bank Chief Economist Kaushik Basu would be another great contender because I'm not sure how much macroeconomic experience Arundhati Bhattacharya has; her immense experience is in retail and investment banking.Footnotes[1] Union budget 2016-17: government announces monetary policy committee[2] RBI leaves retail inflation target at 5% with upward bias

The U.S. Congress - all they have to do is change or repeal the Federal Reserve Act of 1913.However, they would be wise to leave it as it is because of the apparently overwhelming Moral Hazard involved in direct political control of Monetary Policy that one can see from even the most cursory survey of Economic History.See What happens to money (currency) when the central bank in charge of it is not mostly independent of the legislative/political process of the nation?As it is, the chairperson of the Federal Reserve testifies before both houses of Congress about U.S. Monetary Policy, U.S. Fiscal Policy, U.S. Federal Budget, and other matters of Macroeconomics twice a year, by law.See also Who controls the monetary system?