Rajan in chains

A FEW years ago, when Alan Greenspan was boss of the Federal Reserve, a central banker in Europe remarked how much he disliked it when he saw a headline such as “Greenspan cuts rates”. The Fed’s standing was hurt by such a personalisation of its policymaking, he explained. After all, it is actually all 12 members of the Federal Open Market Committee (FOMC) who decide America’s interest rates, not just its chairman.

In India the Reserve Bank of India (RBI) and its present governor, Raghuram Rajan, are as closely entwined in the popular mind as the Fed was with Mr Greenspan. Yet on July 23rd the government published an external commission’s draft of a new financial code, which would reduce Mr Rajan’s authority over interest rates. It proposes to set up a new monetary-policy committee (MPC) with seven members: four government appointees, the governor of the RBI and two other representatives of the central bank.

The proposal was immediately condemned as an assault on the RBI’s independence, but the reality is more nuanced. Unlike the Fed, the RBI is not technically independent. The governor has the authority to set interest rates although, under the RBI Act of 1934, he would be obliged to change them if the government ordered him to. An advisory committee weighs in on his decisions, but it is largely ignored.

The RBI has credibility because of the standing in financial markets of Mr Rajan, a former chief economist of the IMF. A government hoping for cheap money to boost its popularity would not find him easy to push around. The stockmarket and the rupee would plummet if it ever seemed that anyone was trying.

By the time Mr Rajan took charge in 2013, no one was terribly sure what guided India’s monetary policy. Was it output growth? The wholesale-price index? The weather? Mr Rajan moved quickly to establish a clear framework. A commission chaired by Urjit Patel, a deputy governor, recommended last year that the RBI should eventually aim for inflation of 4%, with a target range of 2%-6%. A five-strong MPC, comprised of three RBI officials and two outsiders, would be tasked with meeting this goal. In the meantime the RBI should aim to bring inflation below 6%, the commission recommended.

In March the finance ministry gave its explicit blessing to a 4% inflation target from next year. But it suspended judgment on the MPC. So when the ministry published the draft code on its website, it looked as if the government was seeking to retain (or regain) control over interest rates.

Yet the draft does not argue for an MPC packed with government stooges. It says the four external members should be chosen from a list drawn up by a selection committee of independent experts. The way that members voted, and why, would be a matter of public record within a fortnight of a decision on interest rates.

There is no consensus about the ideal composition of a rate-setting committee. Many, including Britain’s, have external members. Members are also often subject to political vetting of some sort: seven of the 12 voting members of the FOMC, for instance, are appointed by the president and confirmed by the Senate. Even when members from within the central bank command a majority, as at the Bank of England, the boss can still be overruled. That happened several times during the governorship of Mervyn King, for example.

There is a consensus, however, that a committee is superior to one-man rule. In 2000 Alan Blinder, who served on the FOMC, and John Morgan, a colleague at Princeton University, published a paper based on the results of students playing a simple monetary-policy game. They found that committees made better decisions than individuals. A subsequent Bank of England study along similar lines came to the same conclusion.

Nonetheless, the furore in India has been so great that finance-ministry bigwigs have hastily declared that the government will not necessarily adopt the draft code in full. Such is the deference that Mr Rajan commands. Agreement on the creation and make-up of India’s committee, it seems, is still far away. Meanwhile a decision on interest rates, which have been lowered in three steps from 8% to 7.25% this year, is scheduled for August 4th. Most economists expect no change. But there is an outside chance that the headlines on the morning of August 5th will declare, “Rajan cuts rates”.