goi: Takes GoI and RBI to policy tango

At the heart of the argument for central bank ‘independence’ – an issue relatively lost in the melee after Monday’s Supreme Court 4:1 verdict upholding GoI‘s 2016 demonetisation decision – lies the Phillips curve: the relationship between inflation, which central bankers are mandated to control, and employment, a job best left to governments. But a neat division of responsibilities is almost impossible to accomplish primarily because monetary and fiscal policies must work in harmony, which they rarely do. There are also questions over the efficacy of central bank actions over various parts of the business cycle – using cheap credit to revive demand is a bit like pushing on a string, and higher borrowing costs can sometimes be counterproductive when inflation is originating on the supply side. A diffusion of objectives is inescapable and financial markets tend to amplify this policy incongruity, as with their bet on how far central banks are prepared to go in the current battle with inflation. Historical experience points to a policy bias in favour of employment.

The water is muddied further in developing economies where central banks don multiple hats, such as being the government’s debt manager as well as regulator for banks. This adds policy variables to their primary objective of managing inflation. Communicating this objective with the markets as a means to anchoring expectations exposes central bankers to the feedback that renders lawmakers unfit for managing inflation. Sensitivity to market feedback will influence the synchronisation of central bank actions as recession spreads across the world over the course of this year.

Central bank ‘independence’ should ideally make allowances for inflation-unemployment trade-offs specific to an economy’s stage of development and policy transmission capacity. A degree of coordination between governments and central banks regarded as fostering dependence in advanced economies may be necessary in developing economies that have bigger scope for fiscal intervention to build social capital and deliver welfare. Central bank autonomy is a destination. Countries have the flexibility to choose the path.