RBI Governor Shaktikanta Das is about to become the first governor to breach the central bank’s legal mandate on price stability.
By next fortnight, he’ll write to the government explaining the Monetary Policy Committee’s failure for letting inflation out of the barn. The letter will be sent to the Ministry of Finance, through which the RBI is accountable to the Parliament.
Since adopting the Flexible Inflation Targeting (FIT) regime in October 2016, RBI never missed the mandate of 4%, with a 2% leeway on either side. It came close in 2020 following the Covid-19 pandemic, when headline inflation stayed above 6% for 11 months. By convention, Das’ maiden dispatch should have arrived last year itself, but the government reportedly came to his rescue, discarding the April-June 2020 inflation data as unsuitable for computational purposes.
Unluckily for Das, the Ukraine war and the subsequent oil price shocks sent headline inflation soaring once again this year, breaching the target and triggering the need for an explanatory missive. But Das last month noted that any such communication will remain private, between RBI and the governnment. This is a departure from global central banking practices.
The Bank of England writes each time it misses the target and the UK’s Chancellor writes back and the exchanges are placed in the public domain. In fact, the concept of open letters is an integral part of the communication and accountability process, and not a ‘censure’ on the central banks. Which is why the Central Bank of Turkey and others yielded even during the 2020 high inflationary episodes caused to Covid-19 economic measures.
Most recently, the Bank of Japan Governor Haruhiko Kuroda was asked by the nation’s opposition party to take responsibility and resign for missing the inflation mandate and hurting the economy with a weaker yen. Until recently, the Reserve Bank of New Zealand -- the father of the inflation targeting regime -- explicitly binded the tenure of the governor to the inflation target. Then there are countries like the US that even hold parliamentary hearings, where its Governors are called upon to explain policy slippages in person.
In contrast, RBI’s proposed report will be kept private, side-stepping the accountability aspect. Ironically, it was Das who signed off the dotted line during his stint as Economics Secretary. According to a report by The Reporter’s Collective, Das’ letter to RBI then noted that the Governor must write to the government within one month of the failure to meet the inflation target and also place the report in public domain. However, the provision (placing in public domain) wasn’t prescribed in the rules and was to be dealt with administratively.
Truth is, even though the mandate is between a central bank and its government, the former indirectly is in a virtual obligation with citizens. And credibility of an unelected central bank deepens only when it embraces transparency and openness on achievements and failures in equal measure. It’s worth noting that admitting failures may stimulate needless public debate, but it doesn’t always translate to reputational risks.
As Fracasso, Genberg and Wyplosz argued in a seminal paper on ‘How do central banks write,’ way back in 2003, merely announcing inflation targets and publishing forecasts isn’t enough. The benefits only accrue to central banks that convince the public that their decisions are rooted in relatively tight constraints.
Open letters aren’t just about transparency, but could even help improve economic literacy. The general public has relatively little familiarity with central bank functions such as the lags of monetary transmission or even the fact that the assessment process gives less weight to past inflation than to future inflation. For instance, RBI doesn’t change rates based on previous month’s inflation data, but considering future outlook. Sadly, even media headlines scream about rate tweaks, each time inflation hits the skids.
Importantly, it’s also essential to help understand the difference between cost-push and demand-side sources of inflation and the consequent policy responses. For instance, rising oil prices is a supply-side concern, even if temporary, and monetary policy has no business in reducing oil prices. That said, if higher oil prices threaten to percolate through to rising wages or inflationary expectations, otherwise called the second-round effects, central banks step in with rate hikes to protect the inflation target and guard against the risk of a cost-push spiral.
Facing the music
Section 45ZN of the RBI Act defines failure to meet inflation target as well as accountability measures in case of failure
In accordance with Regulation 7 of RBI MPC and Monetary Policy Process Regulations, 2016, a separate meeting is scheduled to discuss and draft the report to be sent to the government
The report will be sent within one month from the date on which the bank failed to meet inflation target
As per sub-sections (a), (b) and (c) of Section 45ZN of the RBI Act, when the bank fails to meet inflation target, it must report to the central government:
(a) the reasons for failure to achieve the inflation target
(b) remedial actions proposed to be taken by the Bank
(c) an estimate of the time period within which the inflation target shall be achieved pursuant to the timely implementation of proposed remedial actions