Revisiting inflation targeting

The debate on inflation targeting has come to the fore once again as Raghuram Rajan, in a statement, and D Subbarao, in his memoirs, have expressed compelling views on this issue. The point is relevant because the perceived conflict between the Reserve Bank of India and the finance ministry over the years has centred on it. The RBI has generally been hawkish about inflation while the government has been arguing for lower rates from the point of view of growth. How do we view this debate?

The curious thing about this so-called discord over inflation targeting is that to begin with, all parties agreed with this objective. An RBI committee recommended targeting CPI inflation even while there were counter-arguments on the appropriateness of this measure. Next, the RBI accepted these recommendations and proceeded to target the CPI. At the final stage the ministry signed an agreement with the RBI that the CPI number would be targeted at 4 per cent with a band of 2 per cent either way. This means that conceptually everyone has agreed to such targeting. The question now is how one perceives an inflation number of 5 per cent. If inflationary expectations are grim, it does not look good, and if external factors are congenial, the number looks low.

Is there a theoretical basis for targeting inflation? Yes, if one is a monetarist, which is what most central banks tend to be. If inflation is believed to be, as Friedman had put it, “almost always a monetary phenomenon”, central banks should target inflation. The ECB or the Federal Reserve always talk of an ideal number of 2 per cent and work around it.

The rationale is that minimum inflation is needed to encourage economic activity; but beyond a point, easy money creates excess demand forces which push up prices. This is the classic case of ‘demand pull inflation’ which monetary policy can curb by increasing interest rates or reserves, or going in for open market operations to handle liquidity.

But if one follows the Keynesian school, then monetary policy can also influence growth and hence there is room for talking of expansion. This is where the government comes in, when the argument is put forward that lower rates will push up growth. Given that the government is not willing to spend by the theoretical Keynesian prescription of fiscal stimulus, the onus is passed to the RBI to lower rates which will enable the private sector to invest more.

There is, however, an argument that excess demand comes in only when full employment is reached and hence as long as there is spare capacity monetary expansion should not be inflationary. Hence both monetarism and Keynesianism can coexist.

But what has been observed globally is that merely lowering rates or even enthusing liquidity by buyback of securities is not adequate to propel economies. When the problem is on the demand side, which is the case in India today, lowering rates has weak effects. People do not buy homes or companies invest when there is less money being earned by households or excess capacity residing in industry. The solution does not exist on Mint Road.

The RBI can only lower rates, but economic agents have to start borrowing more and banks should be willing to lend more given their asset quality challenges. By treating interest rates as the overriding factor driving the economy and focusing excessively on lowering the same, we could just be losing the plot.

It is also a matter of debate whether CPI is the right index to target in the Indian context, as the components of this series are not linked with leverage. In the US, credit cards are used in every sphere of life starting from bus tickets to consumer goods. Hence, viewing the CPI and then targeting the same makes economic sense. But for India, where almost 90 per cent of the index is not based on borrowing, interest rate policy cannot influence this number. The CPI is basically a supply-side phenomenon where shocks in production can set us back considerably. Ideally, the WPI which comes closer to being a producers’ index should be targeted, and going by what has transpired in FY16, negative WPI inflation was not consistent with the conservative monetary policy action of the RBI.

The main takeaway is that monetary policy is one aspect of the framework which can work only to a limited extent, for two reasons. First, we are targeting an inflation rate over which the policy has less control. Second, even if rates are lowered, the decision to spend is a demand-side issue and hence has met with little success.

Two conundrums come up. First, if crude oil prices go up, given that the government has withdrawn the subsidy substantially, prices of fuel products are bound to increase; this will push up inflation. Can the RBI then be pressured to lower rates in a situation where the government has contributed to rising prices?

The second issue is that as there is a lot of focus on growth when it comes to monetary policy, should we abandon the inflation targeting model and start talking of targeting growth? Hence, instead of looking at 6 per cent inflation, the vision can be , say, 8 per cent GDP growth, and as long as we are below this mark, interest rates have to come down. If inflation is on the supply side driven by potatoes and tomatoes, such rates should then be non-inflationary.

At a more realistic level we can also consider fixing ideal rates of inflation and GDP growth, and gear policy to these numbers. This was the RBI’s way of expressing itself before it settled for inflation targeting; when the opening lines of a policy statement referred to growth with stability, without explicitly stating numbers. But casting the target of inflation in stone does constrain policy action as while the band of 2 per cent for inflation allows for flexibility, excluding growth numbers in the approach generates controversy.

Going ahead, it is the monetary policy committee that will work on the structure. It will be interesting to see how the last part of the agreement between the RBI and the finance ministry will be handled in case inflation goes beyond 6 per cent, especially if the tomato or onion crop turns negative. The committee will be answerable.

The writer is chief economist at CARE Ratings. The views are personal