The Expert Committee formed under the supervision of Reserve Bank of India (RBI) Deputy Governor, Urjit Patel released their report to revise and strengthen the monetary policy framework, earlier this year. Since then the report has been heavily discussed and debated in academic and policy circles. It recommends a fundamental change in the way monetary policy is conducted in India. The one recommendation that has been the main talking point so far is the adoption of a flexible inflation target. In this article, we attempt to analyze this particular recommendation of the committee against the backdrop of the current Indian economic scenario.
Monetary policy in independent India has evolved substantially over the past several decades. India adopted widespread liberalization, privatization and deregulation reforms in the early 1990s. During the post liberalization period running up to the present time, the RBI has been following a multiple indicator approach for executing monetary policy. In this approach, information is gathered on various macroeconomic indicators such as output, trade, credit, inflation rate, exchange rate, capital flows etc. Thereafter, monetary policy is designed to fulfill the multiple objectives of increasing employment, closing the gap with potential output, moderating inflation, stabilising exchange rate and so on.
This kind of a multiple indicator approach however, lacks a nominal anchor or a specific target per se and hence it maybe argued that it is less likely to be effective in achieving all the objectives at the same time. Such an approach makes the monetary policy highly discretionary and runs the risk of sending confusing signals to market participants as well as corporations.
In India, the multiple indicator approach of the monetary policy worked relatively well especially between the late 1990s and late 2000s when Indian GDP was growing at a healthy and robust rate of close to 10% or more, and inflation (measured by the wholesale price index or WPI) was moderate at around 5-6%. This was also the time when all was apparently well in the global economy which was going through a phase of relatively low output volatility.
However, all of these ended with the outbreak of the Global Financial Crisis (GFC) in 2008. In the aftermath of the crisis, India’s own macroeconomic health and stability started showing signs of rapid deterioration. Over the last few years in the post GFC era, GDP growth rate has exhibited a sharp and dramatic decline from more than 10% to less than 5% in just 4-5 years, and inflation has been unprecedentedly and persistently high (close to 10% or more), primarily driven by sharp rises in the prices of food and fuel, both of which are crucial items in an average Indian household’s consumption basket. Retail inflation since 2008 has been in the double digits despite the sharp growth slowdown. This has also meant that inflation expectations have gotten entrenched and despite successive round of hikes in the policy interest rates by the RBI, inflation still has not been brought down to the comfortable levels of 5-6%.
Such persistently high inflation not only erodes the purchasing power of the common man, it also leads to low real interest rates on savings, which in turn reduces the incentive of households to deposit their savings in banks. Domestic financial savings have indeed gone down from more than 12% of GDP in 2007 to less than 9% in 2011. Consequently, during the last few years, demand for gold as an alternative saving instrument has sky rocketed. This of course has adverse implications for India’s current account deficit that has been at an all time high over the same period of time; it went up from less than 2% to more than 5% of GDP. A higher current account deficit leads to a weaker rupee, which in turn raises the price of imported items such as crude oil. This has a feedback effect into domestic inflation. As domestic savings go down, and interest rates are raised to control inflation, investment gets hampered thereby lowering GDP growth rate. In other words, high and persistent inflation and inflation expectations can destabilise the economy for a prolonged period of time and hence need to be controlled as quickly as possible.
One of the factors often cited as a reason for inflation becoming persistent and inflationary expectations getting entrenched in the Indian economy in the aftermath of the GFC, was the slow, timid and gradual response by the authorities in the initial years. In India we have almost always been pre-occupied with the objective of raising GDP growth rate rather than ensuring price stability. During 2000-2007, the spectacular increase in growth rate pushed up the rural wages, which raised the demand for essential food items. However the supply of these items continued to be constrained by institutional bottlenecks thereby creating an inevitable demand-supply imbalance, which only worsened over time as the pre-occupation with high growth rate camouflaged several underlying structural issues.
In the period immediately following the GFC when interest rates were lowered all over the world in response to a growth slow down, India followed suit as well, in addition to rolling out a massive fiscal stimulus program, to shield the economy from the adverse external shocks. However, even when the economy started recovering, the stimulus was not reined in leading to a sharp rise in fiscal deficit and neither was monetary policy tightened. Inflation began to increase around this time but authorities responded by raising interest rates with a substantial lag by which time inflation had become too high. Several economists are of the opinion that even then the response of the authorities was less than substantial and robust and at best can be characterised as mild.
One can argue that this kind of a delayed, and insufficient response to rising inflation might have been a direct fall out of a discretionary approach where the reaction is triggered only after a problem has emerged, rather than a distinct and well-defined monetary policy rule that needs to be followed under all circumstances.
Against this background, in principle, inflation targeting (IT) as proposed by the Expert Committee seems like a reasonable strategy to bring down inflation quickly and in a sustained manner and thereafter adjust monetary policy such that inflation remains within the flexible target band. According to the Committee’s Report, in the short run, RBI should try and bring down inflation from the current level to 8% over a period not exceeding the next 12 months, and to 6% over a period not exceeding the next 24 months “before formally adopting the recommended target of 4% inflation with a band of +/- 2%”.
IT is a monetary policy rule that prescribes to the central bank a target or a range of targets for inflation. It was first adopted by New Zealand in 1990 and Chile was the first emerging economy to implement it in 1991. Since then it has become quite popular among both developed and emerging economies. Major emerging economies such as Brazil, Colombia, Peru, South Africa, Indonesia, Turkey, and Mexico have adopted IT.
The IT strategy sets out a well-defined framework for monetary policy formulation and gives a clear way forward which may be a welcome change from the multiple indicator approach currently followed by the RBI that can be quite haphazard. A single variable approach clearly spells out the target and makes it easier for the RBI to follow a rule based monetary policy as opposed to the current discretionary approach. Also with a proper target declared, market participants are likely to get a clear signal regarding the RBI’s monetary policy stance instead of the endless confusion markets suffer now, especially before every monetary policy review meeting. This strategy is likely to bring greater transparency, higher accountability and more clarity, that are important not only for financial market participants, corporations and policy makers at the government level but also for the common man most affected by and least hedged against persistently high inflation rates. Furthermore for a central bank, a primary objective ought to be price stability and IT will help the RBI achieve this objective in a systematic manner. It also lends credibility to the RBI if it is successful in maintaining inflation at the targeted level.
According to the critics of this approach, a single-minded, exclusive focus on inflation may reduce the flexibility of monetary policy and divert RBI’s attention from other important policy objectives such as boosting growth, reducing currency volatility etc. However, a sustained trajectory of low and stable inflation by itself is likely to resolve several other issues the Indian economy is facing right now and create room for a broader agenda of reforms. For instance with inflation controlled and inflation expectations stabilised, monetary policy can become more effective, interest rates can be lowered again and hence investments boosted, which in turn can help to restore the growth rate. Also improved price stability is crucial for overall macroeconomic stability. Moreover, the recommendation of the committee is to adopt a flexible IT rather than a strict IT. The former implies that the objective would be to achieve the targeted inflation rate over the business cycle in the medium run whereas growth can continue to be the focus in the short run.
Overall, IT reduces inflation volatility, anchors inflation expectations, brings macroeconomic stability, helps achieve price stability, and also enhances the confidence of international investors in the Indian currency. Critics may well pose the question as to whether India is ready yet for IT. We may never know the actual answer to this question until and unless we implement the strategy and try to adhere to the announced inflation target and what better time to initiate the discussion on this given the persistently high inflation that has been plaguing the economy for a few years now. As regards the target rate that has been suggested by the committee, for the longest period of time post liberalization inflation has been around 5-6 % and in view of this, the target does not seem unreasonable.
A crucial element of the recommendation of the Committee is that Consumer Price Index or CPI be used as a nominal anchor for targeting inflation. Central banks in all advanced and emerging economies calculate inflation using the CPI. In fact, India is the only country in the world where the RBI does not focus primarily on the CPI but on the Wholesale Price Index (WPI), which however does not include food and fuel prices. WPI also excludes the service sector that now contributes more than 60% of the GDP. Food is a crucial item in an average Indian consumer’s daily consumption basket. Thus a monetary policy designed predominantly on the basis of WPI is bound to be ineffective in addressing inflation problems faced by majority of the country’s population. CPI on the other hand assigns more than 50% weight to food and fuel. Also consumers are affected by the inflation they face in the retail market, which is best reflected in the CPI index.
Having argued in favour of the recommendation so far, it is also important to point out that this strategy is not going be a panacea for all ills. It is true that the current economic crisis has raised questions about the effectiveness of IT given that it ignores asset prices. Moreover in a country like India, supply side bottlenecks play a big role in generating persistence in inflation and IT as a monetary policy strategy is unlikely to be able to address these issues. Also, this strategy alone while necessary may not be sufficient to achieve its objective given the myriad complexities of the Indian economy that make the situation unique and different from other emerging economies that have experimented with IT. There has to be corresponding corrective action in other areas of the economy as well so as to provide support to the central bank’s attempt at bringing inflation under control. For instance, it is important for the central government to practice fiscal prudence and lower fiscal deficit. A systematic fiscal consolidation by the central government can enhance the effectiveness of monetary policy transmission.
In other words, there are some obvious and clear obstacles to IT being effective in reducing the inflation rate to the targeted 4% in the medium run. In India food prices are heavily influenced by factors such as monsoons as well as a plethora of administered prices (such as Minimum Support Prices or MSPs) and subsidies, which are of course outside the direct control of the RBI. This may limit the ability of the central bank to affect inflation expectations in the current economic scenario. To what extent the RBI may succeed in bringing down food inflation by using interest rate as a policy instrument is hence debatable. Recurrent food inflation cannot be curbed by monetary policy alone. There are several underlying structural rigidities, and market inefficiencies that need to be simultaneously addressed as well. These are some of the limitations the central bank needs to be cognisant of as it discusses the merits of adopting IT.
Finally, even if we set aside these hindrances for the time being and assume that adopting IT will be effective in the short and medium run, the real test of the recommendation may come in the longer run. Given the multitude of institutional and political factors that add to the complexities of the Indian economic landscape, any failure on the part of RBI to maintain inflation at the targeted level can do irreparable damage to its credibility. So it must be made clear at the very outset, that deviation from the target is possible as no one can predict the changes in domestic and global economic landscapes, or sudden disruptions to macroeconomic stability owing to external shocks or political disturbances that have a strong bearing on the Indian economy. It must be communicated clearly that any deviation in future does not automatically imply failure to maintain price stability. Such transparency may be crucial to maintain the credibility and accountability of RBI. Needless to say formal adoption of IT comes with a lot of responsibility and commitment to adhere to the target under all circumstances and if it ever has to be abandoned, to have clear, concrete and credible reasons for doing so. Otherwise, it may do more harm than good by permanently jeopardising the credibility of the RBI and the confidence it intends to restore among the Indian people towards monetary policy through this very approach.
To conclude, in India, the efficacy of inflation targeting as recommended by the Expert Committee, will depend upon a multitude of factors and policies and is not going to be merely a function of announcement of a target and then changing the policy rates to achieve the announced target. In conjunction with a rule based monetary policy strategy, it is also important that steps be taken to create the necessary environment for such a monetary policy to be effective. Reduction of the twin deficits i.e. current account deficit as well as fiscal deficit is crucial to make room for effective monetary policy transmission. Furthermore, given the current Indian economic scenario, broad-based reforms are urgently needed to correct the macroeconomic imbalances arising from structural rigidities and to alleviate the supply side bottlenecks. Finally, there has to be a widespread and sustained political will to provide the necessary support mechanism, for this experiment with inflation targeting to be a success story.
