Why do kittens chase shadows? Why do countries ‘target’ inflation via formal mechanisms when an informal practical approach will do? Is it stupidity, innocence or arrogance?
In each case — and there can be many more examples — it’s a combination of all three. Only the proportions vary.
Where inflation targeting is concerned, arrogance constitutes 90 per cent — the belief that the laws of economics, of supply and demand, can be subordinated by deciding the cost of money. It’s like taking vernier callipers to measure the circumference of earth. You need a lot of patience.
So here’s the short point: formalised inflation targeting is a futile pursuit. Look at the record to see why. It doesn’t really work.
It started in 1990 in, of all countries, New Zealand! And it quickly became a fashion. The UK adopted it in 1992 when it went into the European exchange rate regime. The respectability that the Bank of England gave it made all the difference. It became the thing to do.
But through those 30 years do you think it has worked? Not really if you are completely honest. Yet, it has its advocates. They remind me of what Albert Einstein, or whoever, once said: “insanity is doing the same thing over and over and expecting different results”.
So should central banks — note, not governments which cause half the inflation problem — stop this chasing of tails? The answer has to be yes, at least formally. You don’t need a law passed by parliament to do something that can be done without such a law.
India, for those who have forgotten, gave itself this inflation target law in 2016. It did so unmindful of the fact that in 2003 it had given itself the FRBM law, which failed. That law wanted to curb government expenditure.
The World Bank in a 2021 research paper tried to see how the Indian inflation targeting law had worked. It couldn’t say anything definitive because the law had been in operation for just four years, with Covid in-between.
We are alright, Jack
Actually, the fact is that India has always had inflation targeting. It’s just that it wasn’t through a law because the endeavour was to postpone increasing the dearness allowance to government employees for as long as possible. It was as simple as that.
This DA increase used to fall due at 7 per cent inflation. So the target was anything below that. Usually it stayed in the 4-6 range which is what the target is now. That’s not a coincidence. We have always expected annual inflation to be in this range.
But tell me who targets a range? How self-deceiving can you get? The difference between 4 and 6 per cent is huge. Overall, the record shows that Indian inflation management has been exemplary. The reason is that India is a marvellous democracy with universal franchise. Voters punish governments when inflation remains high.
Also, the RBI is always alert and continually nagging the Finance Ministry to be careful with its expenditure. Maintaining the financial stability of India is its first duty — by law. Read the preamble to the RBI Act.
All this rubbish of it having to formally explain to the government if the target is missed for two successive quarters wasn’t there till 2016. It happened, but through continuous discussion.
If anything, it was the government that did the explaining, as to why it wasn’t adhering to previously agreed upon borrowing limits. It’s all there in the RBI’s archives.
There was no monetary policy committee, either. Things worked well despite that. Besides, voting is pointless given its structure and process. But that’s another story.
Reconsider targeting
As an old dog in this game let me repeat: India’s inflation management has been quite spectacular. There have been very few instances in the last 77 years when the rate stayed in double digits for over a year.
And all those episodes were caused by supply shocks like droughts (1960s) and external oil shocks as well as droughts (1970s). That is, food and fuel. Take those out, as the chief economic adviser has suggested, and you get a very different picture.
To keep inflation down, India would compress demand brutally. It was easy to do that in a semi-autarkic economy with credit rationing, fixed exchange rates and no capital convertibility.
But it’s very different now. We are more open both in the product market and the financial markets than ever before. And there are more elections now. So managing inflation is much harder. Indeed, globalisation’s biggest discontent isn’t unemployment, as Joseph Stiglitz says. It is the difficulty in managing inflation.
So should we repeal the 2016 law? Should we ignore it? Should we amend it? If so, how? That’s what needs a good debate. The RBI should start one. It has nothing to lose but its chains.