The case against inflation targeting

The recent report of a committee constituted by the RBI has proposed a radical rethink of the goal of monetary policy and how it ought to be conducted. Specifically, the committee has recommended that the RBI target inflation, and that the means of inflation control be the interest rate that it directly sets, the so-called ‘repo’.

If this recommendation is accepted it will imply a shifting away from the RBI’s erstwhile approach of being guided by multiple indicators, balancing its growth and inflation objectives. But above all it begs the question of whether the central bank can control inflation in India. Two questions come to mind. The first has to do with the record of inflation targeting in the countries where it has been adopted. The second is the relevance of an inflation targeting central bank for India.

To evaluate the argument for inflation targeting one needs to be aware of the global history of monetary policy. It is not as if the case for inflation control is being made for the first time. Only, inflation control had been attempted via control of the money supply.

Central banks had targeted money supply ostensibly as the means to control inflation. Milton Friedman was the

guru of this strategy and Margaret Thatcher his most zealous shishya .

But Thatcher soon discovered that controlling money supply was not akin to turning on and off the water tap. She had to resort to fiscal policy, in itself an acknowledgement of defeat for ‘monetarism’. Inflation did come down in the UK, but it was pointed out that this was the result of declining global commodity prices, and not due to the unemployment that was engineered as a result of her policies.

Low bargaining power

The American central banker Paul Volcker did manage to control inflation in the US by ushering in the biggest recession since the 1930s and tipping Latin American economies into a debt crisis due to the high-interest-rate policy. We see a certain commonality here. Monetary or even fiscal solutions to inflation can result in output loss.

After Thatcher and Volcker, neither the UK nor the US have experienced high inflation, but this is not so easily ascribed to successful inflation targeting by their central banks. It has to do with the decline in union power and the lessened dependence of both these economies on imported oil.

While the US pursued strategic substitution, the UK stumbled into oil in its backyard. And now globalisation has further lowered the bargaining power of labour vis-à-vis capital as the latter is mobile while the former is not.

No more credibility

The aspiration for an independent inflation-targeting central bank for India is part of the project of taking India’s institutional architecture as close as possible to the Anglo-Saxon one.

After the global financial crisis this no longer has credibility. The theoretical case for inflation targeting is built on the assertion that, but for unanticipated inflation the labour market, and thus the economy, would achieve an optimum that cannot be improved upon by policy. So, unanticipated inflation causes a costly distortion to be avoided.

As it is held that the central bank is ultimately the cause of inflation, in this worldview it must be held to account via an explicit agreement with government that it will target inflation.

Those who argue for inflation targeting assert that today’s inflation is determined by the expectation of inflation tomorrow. Asserting further that the central bank controls inflation, they propose that the central bank merely needs to announce a lower inflation target and a rational public will scale down expectation of inflation and thus lower its actual level.

This sits uncomfortably with history. An institution as formidable as the Bank of England has had to write repeatedly to the government explaining why it slipped on the inflation targets agreed upon.

The Indian picture

We now come to India. Despite its shrinking share the agricultural sector plays an important role in generating and sustaining inflation.

This is due to its weak response to a supply-demand imbalance. Natural factors, poor infrastructure and low human-resource development conspire to bring this about. But we also know that some part of the recent food price inflation has little to do with supply. It has to do with the relentless hiking of producer prices even as public stocks have piled up.

The government has continuously raised the farm price for cereals irrespective of its impact on inflation. In the face of both types of food inflation – supply-demand imbalances and higher producer prices -- a central bank has no instruments. The RBI’s justification that it “anchors inflationary expectations” by raising the interest rate is no more than whistling in the dark.

As a general rule, attempted monetary solutions to supply-side inflation result in the inflation rate being brought down via slowing output growth. We have seen this in the UK and the US in the 1980s, and we see it in India over the past three years or so.

Note that the news that inflation is slowing now must be read along with the information that manufacturing is struggling to grow. Inflation control in India must start with fixing the agriculture price rise. Increasing productivity would be the sine qua non here.

Does a secondary role, if at all, with respect to inflation control render the central bank irrelevant in India? Far from it. A central bank is the main regulator of the financial system. The RBI has a pretty good record here. It also has a reputation for being at arm’s length with private banks and finance companies. This is in sharp contrast to the Greenspan years in the US when Wall Street is believed to have been treated with kid gloves.

However, there is one area in which the RBI fails quite miserably: this is in regulating the note issue on which it has the monopoly. Across India one is confronted with shabby currency notes and an endemic shortage of smaller denomination notes and coins. Attempt to take a taxi-ride or buy a cup of tea and you find yourself struggling to complete the transaction.

There is creeping inflation when prices have to be rounded-off upwards to ensure that exchange takes place. In sum, the RBI has its task cut out.

The writer may be reached at www.pulaprebalakrishnan.in