Financial Standards and Codes: Report of The Advisory Group on
Transparency in Monetary and Financial Policies - Process of Monetary Policy Formulation

Fiscal Responsibility Act

There is a strong interaction between the RBI’s responsibilities in the areas of monetary policy and internal public debt management. With the large fiscal deficit in recent years and the consequent large market borrowing programme of the government, there has been, for many years, an overarching of debt management policy on monetary policy. The large monetisation of the fiscal deficit and below market clearing interest rates on government paper significantly attenuated the effective functioning of monetary policy. In the process, the monetary policy function has become somewhat subservient to debt management. This is compounded by the fact that the RBI statutorily acts as the fiscal agent of the government in managing the public debt. In such a system there could be overt or covert pressures from the government to monetise the debt, to accommodate the borrowing programme by easing liquidity and softening interest rates.

Assigning the debt management policy function to the RBI puts the RBI into a direct conflict of interest situation as between debt management and monetary policy. In such a conflict it is the effectiveness of monetary policy which is a casualty. Interest rates are one of the most powerful instruments of monetary policy and the Advisory Group recommends that the determination of interest rates should be exclusively a monetary policy function.

The Advisory Group hopes that the proposed legislation for a Fiscal Responsibility Act would, inter alia, clearly delineate the responsibilities of fiscal policy and monetary policy. Transparency in fiscal policy and monetary policy are clearly interrelated. In this sense, autonomy of the RBI is the obverse of a Fiscal Responsibility Act.

A majority of central banks are prohibited from participating in the primary issues of government debt and it is time that the RBI falls in line with this general practice. The Advisory Group recommends that there should be well calibrated legislative measures to separate debt management and monetary policy functions.

The Advisory Group urges that the government should set up its own independent Debt Management Office to take over, in a phased manner, the present debt management functions discharged by the RBI. The payments and settlement function should, however, continue with the RBI. The separation of debt management and monetary management would bring about greater transparency and more effective monetary management as the RBI would then orient its use of instruments to meet the monetary policy mandate set out to it rather than the present situation in which debt management overarches on monetary management. The Advisory Group recognises that separation of debt management and monetary policy is a necessary but not a sufficient condition for an effective monetary policy which would also require a reasonable degree of fiscal responsibility.

The traditional argument in favour of an autonomous central bank is that the power to spend should be separated from the power to create money. The type of autonomy which is required would be one where the central bank would periodically report to the legislature in contrast to a situation wherein its policy decisions are under continuous scrutiny by the government. The Advisory Group is of the view that what the RBI needs, by way of autonomy is headroom to operate monetary policy and this it would have once debt management is separated from monetary policy and the fisc is in reasonable balance. The RBI would continue to have a role in maintaining orderly conditions in the government securities market by operating in the secondary market via its open market operations which is an important instrument of monetary policy.

The RBI would need to prepare itself for the details of transparency. While the devil is in the details this should by no means inhibit the RBI from accepting the challenges posed by increased transparency. In this context the RBI and government should evolve a blueprint for the process of monetary policy formulation. The Advisory Group recommends that over a phased period as debt management is gradually distanced from monetary policy the government and RBI should progressively work towards greater clarity in publicly setting out the objectives of monetary policy. The RBI should evolve a move to greater transparency is setting out the process of monetary policy formulation so that accountability of the RBI can be properly assessed. Again, during the phased period the RBI should sharpen its instruments to make them effective and in particular it needs to hone its skills of open market operations.

There is great comfort in a multiple objective approach in that precision is not required in defining the objectives and the RBI in turn does not have much accountability as it juggles with the almost impossible task of fulfilling contradictory objectives and as such accountability is blurred. The Advisory Group recommends that with a view to moving towards a more transparent system it would be best to veer towards prescribing to the RBI a single objective while the government could have for itself a clearly set out hierarchy of objectives for which it could use its other instruments of policy. Indian monetary analysis and the public perception thereof suffers greatly from the ailment of contradictory principal objectives. For instance, as a large continental economy great store is laid, and appropriately so, on the independence of monetary policy but at the same time we expect to have an independent exchange rate policy. Basic monetary analysis would indicate that a country that wants an independent monetary policy cannot have an independent exchange rate policy and vice versa. Again, there is a popular belief that both interest rates and money supply can be controlled. There is a confusion of instruments and objectives and the Advisory Group recommends that, apart from erudite analysis, which is incomprehensible to the public at large, there is much merit in the authorities clarifying issues in monetary and financial policies in simple language intelligible to the general public.

The conflict of single versus multiple objectives can be resolved by a refocussing on objectives and instruments. Illustratively, in a multiple objective approach a government would like to achieve a high real growth rate, a low inflation rate, a large market borrowing programme, a low interest rate, moderate growth of money supply a healthy growth of foreign exchange reserves and a rock stable exchange rate. If indeed such a mix of objectives is set for the RBI there would be a complete obfuscation of objectives and transparency would be absent and as such accountability would suffer. It should, however, be possible to set out a single monetary policy objective and the other ancillary objectives can provide a backdrop for the government against which the single objective could be set for the RBI. Illustratively, the government can, as is done in the UK and New Zealand, unequivocally set out to the RBI a medium-term inflation objective, say over a prospective three year period, and while fixing this objective take cognisance of other objectives and the government can retain the right, with Parliamentary endorsement, to reset the single objective in the light of evolving developments. What is important, however, is that the initial statement and consequent resetting of the objective should be done transparently and the rationale of the change should be fully explained. For instance, a war or a devastating drought or other major natural calamity or a severe external shock could warrant the resetting of the single objective. For purposes of credibility, however, frequent resetting of the objective, for a particular period, should be the exception rather than the rule. If the issue regarding the objective of monetary policy is satisfactorily resolved, the stage would be set for greater transparency in the process of monetary policy formulation. For this process to be meaningful it would, however, be imperative for the government to ensure transparency in the setting out of objectives of overall economic policy.