The debate over Central Bank’s autonomy has also come up in the US. President Donald Trump has been engaging in a Twitter war with the Federal Reserve against its policy of raising interest rates. India is not new to this issue.

Relationship between central banks and governments around the world is debated:

Central banks everywhere, from Turkey to the US, are under increasing pressure from the governments. While central bankers say that they need to be free from pressures from the governments and lobby groups to focus on their job of containing inflation and maintaining financial stability, their critics say that they are too secretive and have leaned in favour of big financial institutions over the interests of common citizens.

In News:

1. The mandate of the Reserve Bank of New Zealand (RBNZ), which first put in place an inflation targeting regime was changed from its sole objective of price stability to also include fostering sustainable employment.
2. In the UK, the Bank of England and Her Majesty’s Treasury signed a memorandum of agreement on the financial relationship between the two outlining the framework for determining its capital, payment in lieu of its dividend, issue of notes and the information sharing arrangements between the Bank and the Treasury.

Why the government should have a say in Central Bank’s roles?

In a democracy, the elected representatives should have the last word on how the country should be run. The government should decide on the amount of emphasis on job creation versus inflation targeting.

Given the immense power the central bank has in influencing the economy, a fully autonomous central bank can easily design policies to thwart the will of the people. For example, voters elect a government to create more jobs, but the central bank can keep interest rates high to stifle investment and, consequently, job creation.

Concerns and challenges associated?

Although the government is elected by the people and is supposed to act in the interest of the electorate, politicians whose chief concern is winning re-elections run it. Therefore, Politicians will have a natural tendency to engage in deficit spending (free handouts, higher support prices, and investment projects by state-owned enterprises) just before or just after elections to boost their chances. Politicians can also use the state-owned banking system to benefit their constituents by granting loan waivers.

These policies are not only inflationary but will also adversely affect the health of the banking system. The costs of these policies in the long run far outweigh their short-term benefits to a subsection of the population.

Why Central Banks should have autonomy?

Take the example of India. Successive governments, both at the States and Centre, have implemented farm loan waivers to win elections. Controlling the harm from such actions is the case for an independent and autonomous central bank. Such a central bank can fight the inflationary pressures resulting from deficit spending and also potentially reduce the benefits of such government handouts in terms of economic growth. This, in turn, will reduce the government’s incentives to engage in such handouts in the first place.

An independent Central Bank may have more credibility. If people have more confidence in the Central Bank, this helps to reduce inflationary expectations. In turn, this makes inflation easier to keep low.

What’s the issue with India?

In India, RBI does not have formal autonomy. While RBI’s mandate is to ensure price stability keeping in mind the objective of growth, its board is dominated by government nominees. In effect, the government has formal control over RBI.

Current point of contention between RBI and the government:

Section 7 (1) of The Reserve Bank of India Act, 1934, became a contentious issue after the tension between the central bank and government turned into a public spat over the last few months.

What is Section 7 of RBI act and how it empowers centre to intervene in the functioning of RBI?

Section 7 says: The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.

• Subject to any such directions, the general superintendence and direction of the affairs and business of the Bank shall be entrusted to a Central Board of Directors which may exercise all powers and do all acts and things which may be exercised or done by the Bank.
• Save as otherwise provided in regulations made by the Central Board, the Governor and in his absence the Deputy Governor nominated by him in this behalf, shall also have powers of general superintendence and direction of the affairs and the business of the Bank, and may exercise all powers and do all acts and things which may be exercised or done by the Bank.

Clearly, the section empowers the government to issue directions in public interest to the central bank, which otherwise does not take orders from the government.

What needs to be done?

Fine balance:

There has to be a forum within the democratic structure where the RBI is obligated to explain and defend its position on its policy decisions.

• The governor should be responsible and accountable to Parliament and not to a particular government or the ministry of finance, or minister. He can testify to Parliament twice a year. In separate testimony in both houses of Parliament, the lawmakers can ask questions of the RBI Governor and the latter can respond.
• A better way to sort out these differences and to come to a conclusion is to have a larger debate with technical experts weighing in.
• On issues of operational autonomy, the central government needs to lay off its pressure on the RBI. On macro issues such as exchange rate management and RBI’s dividend policy, written agreements that clearly demarcate roles and responsibilities can be thrashed out.

Way ahead:

RBI is autonomous but within the framework of the RBI Act. It is thus clear that the central bank cannot claim absolute autonomy. It is autonomy within the limits set by the government and its extent depends on the subject and the context. Ultimately, it is the elected representative ruling the country who is answerable to the citizen every five years. The representative while explaining the economy’s performance to own up for everything, including the RBI’s actions, as his own. Therefore, the time is ripe for bringing in a fine line between RBI and the government which does not undermine the Central Bank’s autonomy on one hand and limits absolute autonomy on the other.