Credibility of Indian monetary policy - rules versus discretion - analysis of factors

Abstract

1. INTRODUCTION There seems to be a wide consensus emerging the world-over that monetary stability should be the primary concern for a central bank. During the last few years, this consensus has manifested itself in a wide-ranging revision of the statutes and laws regulating the functioning of central banks in various developed as well as developing nations. These legal statutes now incorporate the principle that price stability should be the primary goal of the central bank and that all other objectives should be pursued only in so far as they are not in direct conflict with the achievements of this primary objective. In many economies that are currently in the stage of transition, central bank laws have also followed the same standard. The debate on whether monetary policy is best conducted under a regime based on rules or alternately, in a framework where discretion prevails has been raging for the last seven decades. Indeed, this debate transcends boundaries and goes far beyond the realms of monetary policy and economic management in general. Not surprisingly, as in any well-meaning debate, two completely diametrically opposite views have emerged in this context: namely, the National perspective and the other, the International perspective. The debate on whether to rely on rules or discretion to decide policy questions has a long history. The central question in the debate is to determine what, if anything, within the monetary policy domain, should be governed by rules and what, if anything should be left to the discretion of the policymaker. The History and Evolution of Central Bank Independence A century ago there were only 18 central banks, 16 in Europe, plus Japan and Indonesia. Today there are 172 central banks and over recent years the number of central banks that claim some degree of independence within government has steadily increased. More central banks have become independent in the 1990s thanin any other decade since World War II. Changes in Britain, Japan, and continental Europe made 1998 a banner year in the history of central bank independence. The Bank of England, one of the oldest centralbanks in the world, was founded by an act of Parliament in 1694. It was involved in commercial activity until the end of the 19th century, but it had gradually shifted during those 200 years toward exclusive focus on central bank activity. The Bank of England had substantial independence for much of the 18th and 19th centuries, but by the 20th century it had essentially become an agency of the British Treasury. Then, in June 1998, it was reborn as an independent central bank under the current Labor government. The Bank of Japan gained operational independence in April 1998. The Bank is still not legally independent, a status prevented by the Japanese constitution. In addition, representatives of both the Ministry of Finance and the Economic Planning Agency attend meetings in a nonvoting capacity. But before then, the Ministry of Finance could require the Bank to delay implementation of a change in policy; now it can only ask. Recently, the Ministry of Finance indeed asked the policy committee of the Bank of Japan to delay a decision to raise the Bank's target interest rate. In an exercise of the Bank's newly attained power, the policy committee rejected the request. The European Central Bank (ECB) began operating on June 1, 1998, and assumed responsibility for monetary policy in the euro area on January 1, 1999. The ECB is the world's first supranational central bank and probably qualifies as the most independent central bank in the world. The charter for the European System of Central Banks (composed of the ECB and the national central banks of the member countries) is an international treaty that can be changed only by unanimous consent of its signatories. With its supranational status, the ECB is further removed from the political pressure of national governments than even the most independent national central banks. In addition, there is no political counterpart to the supranational ECB. The European Parliament carries out oversight hearings on monetary policy but doesnot have any authority with respect to the ECB.