September 05, 2017
Anniversary evaluations are a ritual in almost every sphere of human life. It is an opportunity to reflect, retrospect and review. It is also an opportunity to learn, adapt and improve. At periodic milestones, it is a healthy practice to indulge in honest evaluations of important people in responsible positions in public life. Monday is the first anniversary of Urjit Patel as the Governor of the Reserve Bank of India. What is the legacy of Patel’s first anniversary and what lessons can he learn from it for the remainder of his term? Undoubtedly, the spectre of the government of India’s demonetisation policy of November 2016 looms large over Patel’s first year as the Governor of the RBI.
Equally important but much understated is the potentially enduring legacy that Patel could leave behind as the chief architect of the RBI’s structural transformation as an inflation targeting institution.
First, it is important not to pussyfoot over the fact that the RBI’s abject surrender to the government’s demonetisation idea has cast a deep and long shadow on the institution. The question is not one of whether the RBI had powers to say no to the executive’s decision. Instead, it is about Patel communicating to the government, his intellectually honest opinion of a policy measure that was thrust upon the RBI. The government could have still chosen to overrule the Governor and impose demonetisation but there is no evidence that there was any analysis and opinion presented to the government by the RBI before the introduction of a policy of such magnitude.
As I have demonstrated in this article, it was rightfully expected of the scholar in Urjit Patel to undertake a rigorous analytical exercise of the costs and benefits of such a policy exercise and present it to the government before making a decision. By not doing so and succumbing to the pressures of the government, Patel allowed aspersions to be cast on both himself and the institution of the RBI.
The subsequent diffidence and reticence of the RBI in revealing information has further exacerbated doubts and suspicion over the integrity of the institution and the Governor.
Explanations that the Governor did not have a choice in the policy or that the RBI did remarkably well in ensuring the economy did not suffer from a prolonged shortage of currency notes are shoddy attempts in placation. It is imperative, to be honest and not equivocate about the adverse impact of demonetisation on the credibility of the RBI and Patel. To be sure, other policy measures such as resolution of bad debts of banks are laudable but too early to be judged.
However, Patel still has one opportunity to wipe clean the enormous blemish of demonetisation on his legacy.
The history of the RBI is littered with tales of North Block versus Mint Street conflicts over interest rates. Central banks across the world are subject to an intense clamour for lower and lower interest rates by ruling political parties, driven by pressure from their corporate donors. It is in this context that Urjit Patel could well emerge as the man who instituted structural independence of monetary policy in India.
This can be achieved through the successful implementation of the new inflation targeting framework for the RBI. Urjit Patel has been at the forefront of this change, first as the chairman of the committee that laid out the blueprint and now as the governor to implement it. Under this framework, the RBI’s sole goal is to ensure consumer price inflation in India is between the range of 2 percent to 6 percent. The Urjit Patel Committee submitted its report on inflation targeting in January 2014. The government of India adopted the recommendations in 2016.
With a specific inflation target to be achieved through an independent monetary policy committee, the monetary policy of India can no longer be held hostage to whims and pressures of the RBI governor or the finance minister.
This has gotten off to a good start and there have been six meetings of the monetary policy committee till date. Yet, it is still early days to be secure in the belief that India has successfully transitioned to an inflation targeting monetary policy regime. By the time Patel finishes his tenure as governor of the RBI, he has the opportunity to emerge as the architect of the ‘new and emboldened RBI’ which would more than make amends for the demonetisation disaster.
For any inflation targeting central bank, people’s expectations of inflation play a critical role in determining its success. In other words, what the common household, business or professional thinks of inflation has a role in determining what the actual inflation will be. It is thus important for an inflation targeting central bank to actually target inflation expectations.
Indian households and businesses continue to expect double digit inflation despite actual CPI inflation being in low single digits.
According to RBI’s inflation expectations surveys, a majority of Indians – homemakers, bankers, daily workers, and businesses – continue to believe prices will rise by 10 percent or more in a year. Contrast this with an inflation target of 4 percent that the RBI is mandated to achieve. Many decades of punishing inflation have subconsciously etched high inflation expectations among most Indians. This, in turn, affects actual inflation since the consumption behaviour of people is in part determined by what they think of price levels in the future. This wide gap in people’s inflation expectations vis-à-vis RBI’s inflation target will need to be narrowed for India’s inflation targeting regime to be a success. This can be done only if the RBI and its governor succeed in convincing most Indians that the era of high inflation is over.
For most Indians to lower their inflation expectations, they need to both see and hear low inflation all around them.
They can see low inflation through actual prices of goods and services. But they also need to hear and be reassured that prices will be stable. They can be reassured only by the governor of the RBI. Patel should perhaps speak more, not just to policy makers and economists, but also to real people to assure them that the RBI is protecting their backs from rising prices. This is not to be misconstrued as a call for Patel to be delivering sermons on all sundry topics. In an era when the aam aurat’s (homemaker) expectations of inflations are essential to India’s monetary policy decisions, it is essential for the governor of the RBI to play a big role in shaping those expectations and inspiring confidence.
If Urjit Patel in his tenure can succeed in structurally lowering inflation expectations of Indians, it would ensure the success of inflation targeting and cement the transformation of the monetary policy framework in India.
Let us honestly acknowledge that Governor Urjit Patel’s tenure as RBI governor has had a rocky and tumultuous beginning. Let bygones be bygones. There is still an enormous opportunity for Patel to etch his legacy in the annals of RBI history by eradicating inflationary fears of his fellow Indians and fortifying India’s inflation targeting framework culminating in an institutionalised monetary policy regime for the nation.
Praveen Chakravarty is a Senior Fellow at IDFC Institute, a Mumbai-based think/do tank. His work focuses on financial sector legislation & political economy.