On inflation targeting
It is just one element of the new architecture of macroeconomic policy. Much more is required to shore up the economy
The government has made a wise choice for the Reserve Bank of India (RBI) governor in Urjit Patel, who has the domain knowledge, experience and professional standing that the job demands. He has a reputation of being an inflation hawk, though his favoured avian identification is with a watchful owl! He now has the responsibility for implementing the Monetary Policy Framework Agreement (MPFA).
Under this concordat, “…the objective of monetary policy is to primarily maintain price stability, while keeping in mind the objective of growth”. Price stability, as measured by the consumer price index (CPI), is specified as an inflation target which the central government determines in consultation with RBI. The current target is four per cent with a two-per cent flexibility margin on both sides. RBI has to publish an operating procedure of monetary policy, six monthly assessments of the sources of inflation and forecasts for six to 18 months ahead. If the rate of inflation is beyond the flexibility limits for three quarters, RBI has to report on reasons for the failure, remedial actions and the time period for reaching the target. The monetary policy framework will be operated by RBI but a crucial ingredient, the policy rate, has to be set by a six-member Monetary Policy Committee chaired by the governor, with equal representation from RBI and the government.
The primary purpose of the monetary policy is to provide a nominal anchor for the economy so that changes in the absolute price level, or the rate of inflation in everyday language, remains constrained within acceptable limits. The question that arises is: Acceptable to whom and for what purpose? Someone who holds no financial assets and has no financial liabilities would not be much affected by high or low inflation rates if they affected all goods and services, including his own factor supplies, equally. His real income and wealth would remain unchanged. Inflation matters because a significant part of savings and borrowings are denominated in nominal currency and the rate varies between commodities so that relative prices and, therefore, relative income and wealth are altered.
For a long time the anchor was provided by an external peg such as the gold standard or later a fixed peg to another currency. But with fixed exchange rates and free capital movement, an independent monetary policy was not possible — well known as the central bank “trilemma”. With the collapse of the fixed exchange rate system and the inflation engendered by the oil price shocks and petro-dollars sloshing around in the global financial system, another anchor was needed. This was provided by rules about money supply growth rooted in the quantity theory of money and prices. But soon enough, it became obvious that the demand for money was not stable and that is when inflation targeting emerged as a practical alternative.
Inflation targeting was embraced by 28 central banks from 1990 onwards, the first adopters being the “white commonwealth” countries – the UK, Canada, New Zealand and Australia – possibly under the intellectual influence of the Bank of England. A few developed countries and several developing ones followed suit. But the central banks US, Eurozone and Japan have not explicitly adopted inflation targeting. The impact of inflation targeting on inflation behaviour remains a source of contention. However, its impact on moderating inflation expectations and, through that, on savings and spending is more widely accepted.
Inflation targeting in its pristine form requires a severe policy discipline. As the International Monetary Fund brief on the subject states “…the inflation target takes precedence over all other objectives of monetary policy” and requires “…the willingness and ability of the monetary authorities not to target other indicators, such as wages, the level of employment, or the exchange rate.” Will this severe discipline hold and should it hold?
First inflation targeting in India must recognise that the weight of food and energy items in the CPI is 52.7 per cent and their prices are largely determined by supply-side factors, which are not readily influenced by monetary policy measures. If RBI is to be accountable for inflation rates then there must be an equally structured mechanism for holding accountable the authorities whose actions influence these supply-side factors.
Second, the fiscal counterpart to inflation targeting is deficit targeting which is subject to the Fiscal Responsibility and Budget Management (FRBM) Act whose operations and flexibility mechanisms are currently under review by the N K Singh committee. Hopefully this committee will suggest some symmetry in the accountability mechanisms between the MPFA and the FRBM.
These conservative approaches to macroeconomic policy are a response both to the earlier laxity of fiscal and monetary policies and to the freeing of trade and investment flows after 1991. But their implementation remained erratic as the government, which is the biggest borrower and spender, wanted to be virtuous but not just as yet. Thus a major departure from fiscal rectitude is the way the governments have misused their ownership of financial institutions to hide fiscal gaps by appropriating resources which rightfully should only be deployed to serve the interests of depositors and savers
A more defensible reason for the departures from fiscal virtue is the importance of growth and related real economy objectives. Even the famous Taylor rule in its simplest form recognises that the nominal interest rate should respond to divergences of inflation rates from the target and of actual GDP from potential. The MPFA recognises that the growth objective must be taken into account. But the reporting, forecasting and accountability mechanisms focus entirely on the inflation rate. Hence, a structured dialogue between RBI, the finance ministry and NITI Aayog on short- and medium-term real economy concerns, arising from domestic or international shocks, must inform the operations of the MPFA, the Monetary Policy Committee and the FRBM mechanisms. Monetary policy also has to be ready to tackle asset price bubbles and volatility in international financial flows. But the reaction time in these matters is short and one has to rely largely on the alertness and market acumen of the RBI and the finance ministry.
Inflation targeting is just one element in the new architecture of macroeconomic policy. A structured assessment of trends and fluctuations in the real economy, a more effective FRBM in the Centre and the states, arms-length management of public debt and borrowing, independent forecasting of inflation and deficits, perhaps under parliamentary auspices, goods and services tax and other measures to integrate fragmented markets are some of the further steps required.