The government and RBI are in the process of finalising the structure of India’s Monetary Policy Committee. In this article, Amartya Lahiri, Professor of Economics at the University of British Columbia, makes recommendations for the composition of the committee that would help preserve the independence of the RBI in monetary policy oversight and conduct in form and spirit.

The second draft of the Indian Financial Code (IFC) that was circulated on July 23, 2015 was widely perceived as the government trying to curtail the independence of the Reserve Bank of India (RBI) in determining the course of monetary policy. The media discussion regarding the proposed structure of the Monetary Policy Committee (MPC) has focused on two aspects: composition of the committee; and veto power for the RBI governor over MPC decisions. Specifically, the revised draft proposed that the seven-member MPC, which would choose monetary policy in India through a majority vote, be composed of three members from the RBI and four government nominees. Moreover, the revised draft did not give the RBI Governor (renamed the Chairperson, for somewhat unclear reasons) veto power over the committee’s decisions, as opposed to the initial draft.

Before going into the specific arguments, it is important to point out that the recommendation that monetary policy decisions be handed over to an MPC actually originated from the RBI itself as part of the report of an expert panel headed by Deputy Governor Urjit Patel. This panel was set up by Governor Raghuram Rajan himself and tasked with conducting a root-and-branch review of the monetary policy framework in India. Hence, the headlines that the government is trying to neuter the RBI by proposing a committee and not giving the Governor a veto is entirely off-base. The Patel committee proposed an MPC and didn’t recommend a veto for the Governor either.

Veto power contradictory to committee approach

The reasoning behind the panel’s recommendation that monetary policy be conducted by a committee was that an MPC would minimise the chances of a bad/wrong decision due to the wrong judgement of any one person (the Governor), however well-intentioned he/she may be. This is widely accepted globally and is the reason why most central banks take monetary policy decisions through committees rather than vesting them in the hands of one person. In light of this, the current debate should not be couched in terms of whether or not to have a committee. The answer to that is fairly clear. Rather, the focus is, and should be, on the optimal design of the MPC.

Before discussing the design of the committee, it is useful to address the issue of a veto for the RBI Governor. Since the logic for handing over monetary policy decisions to a committee is mainly to avoid the pitfalls of dictatorial decisions by an individual person, handing the Governor a veto over MPC decisions would be remarkably self-defeating. Indeed, Rajan himself has come out against the idea of giving the Governor a veto. Few central banks with a committee approach give the committee chairman such a veto.

Composition of the committee

The key issue then is the composition of the MPC. Given that one of the primary goals of the proposed reform is to provide the RBI and the MPC with independent jurisdiction over monetary policy subject to the government and the RBI agreeing on the precise inflation target, the originally proposed seven-member committee with four government appointees attracted a lot of criticism and debate. Some of this criticism was well-placed. Handing a majority of MPC seats to government nominees creates a potential situation where the government could dictate monetary policy (if its nominees collectively choose to do the government’s bidding). This particular situation would be akin to handing the government a ‘tails I win, heads you lose’ instrument since it could choose the monetary policy it desires and yet blame the RBI if the agreed upon inflation target is not met.

There are two approaches that might provide a simple solution. The first would be to have a seven-member committee with three RBI members, two nominated by the government and two outsiders to be nominated either by the RBI or jointly by the RBI and the government. The second would be to have a six-member committee with three RBI and three government nominees with the Governor of the RBI, in his/her capacity of being Chairperson of the MPC, having a casting vote. That way we can have a committee with the independence of the RBI in monetary policy oversight and conduct being preserved both in form and spirit. It seems that the negotiations between the Finance Ministry and RBI are likely to arrive at this latter solution.

A final word is possibly in order regarding the choice of the government and outside nominees. In India, memberships in expert committees often end up being routinely handed out to retired bureaucrats. The point of a committee is to have the benefit of opinions of people from diverse backgrounds with specialisation that is relevant to the task of the committee. It may be worthwhile building in safeguards to prevent the MPC from becoming a parking space for career bureaucrats, past and present.