Fighting inflation: the RBI and the Fed

The RBI and the Fed both enjoy a degree of independence or autonomy as central banks. At the moment, however, the two central banks seem to want to use their independence in quite different ways. The RBI would like to focus on inflation- it would like to bring the inflation rate down to 8% by January 2015 and 6% a year later. The finance ministry would like the RBI to give a little more weight to growth than the above policy would suggest. The RBI's present course run the risk of a collision with the finance ministry, as this report warns.

In the US, the situation today is rather different. The US Fed is taking a quite different approach at the moment. It would like to stick to its broad mandate of addressing both price stability and growth. However, the US Congress would like a sharper focus on price stability, as this article by Martin Feldstein points out. The US Fed is independent of the executive but not completely independent of Congress. The Congress is now pushing legislation that would commit the Fed to a monetary policy rule, namely, the well known Taylor rule. The Fed is resistant to such a rule for obvious reasons. Given an inflation target of 2 per cent, the Taylor rule would determine the fed funds rate which would end up much higher than today's rate:

It (the Taylor rule) states that the federal funds rate should be two per cent plus the current inflation rate plus one-half of the difference between current and target inflation and one-half of the percentage difference between current and full-employment gross domestic product (GDP). ....f the GDP gap is four per cent, as a recent Congressional Budget Office estimate implied, the Taylor rule would indicate an optimal federal funds rate of about 1.25 per cent (2 + 1.5 - 0.25 - 2), compared to the current rate of only 0.1 per cent.
While the federal funds rate may be heading to one per cent over the next 12 or 18 months, by then the narrowing GDP gap will imply an even higher Taylor-rule interest rate. And, complicating things further, given United States banks' vast holdings of excess reserves as a result of the Fed's bond-buying policies (quantitative easing), the federal funds rate is no longer the key policy rate that it once was. Instead, the Fed will be focusing on the interest rate on excess reserves.

Western central banks tend to be more hawkish on inflation than those in developing countries. Today, it would seem that the roles are getting reversed where the US and India are concerned.The US is willing to trade-off a little inflation with growth but not the RBI at the present level of inflation in India.