RBI going beyond inflation targeting
The Reserve Bank of India should focus on output at least as much as it does on inflation, but this sits uncomfortably with the mandate of inflation targeting proposed in the draft Indian Financial Code
In a commendable infusion of transparency into policy making, the Government of India has uploaded on the net a draft of the proposed Indian Financial Code (IFC). Within days of its being made available, it had received critical attention in the media. However, though the Code will apply to a wide range of matters financial, much of the response has concerned the monetary policy function. Within this, the focus has been on the relative power of the Reserve Bank of India (RBI) and the government in setting the policy interest rate. The draft, in effect, proposes that the government should have the greater say as, numerically, the government's nominees are set to dominate the Monetary Policy Committee envisaged in it.
This issue is easily resolved in principle. There can be no question that if the RBI is to be held accountable for monetary policy it should have full power to set the interest rate. An impression has been given that the proposal is itself only a manifestation of the government's attempt to cut the RBI leadership down to size. Naturally, this gives rise to some excitement among the public, but there is a much more fundamental issue at stake in the draft IFC, and this has received less than its due attention. It concerns the goal of monetary policy, and it is worrying that on this there is actually no disagreement between the government and the RBI! The draft IFC proposes that the goal of monetary policy shall be inflation targeting. "Inflation targeting" implies that the Central bank will give priority to the rise in prices. This had been the substantive recommendation of The Expert Committee to Revise and Strengthen the Monetary Policy Framework, constituted by the RBI in 2013.
To anyone who rightly worries about inflation, it is appropriate that the Central bank should be concerned with it. But to recommend that a Central bank focus on inflation does beg two questions. First, how effectively can the RBI control inflation? And, second, are there possibly adverse effects of attempting such control? The promise of inflation targeting is that inflation can be controlled by monetary policy and that there are no tradeoffs to a policy of inflation targeting. This can hardly be assumed, and has been strongly contested by economists.
Going by recent history, there is reason for some scepticism about the RBI's ability to control the inflation rate. From 2008 onwards, inflation had shifted gear upwards for five years. It would be difficult to square this with the suggestion that it reflects the Bank's efforts to maintain growth, for growth has actually been lower in this period. While we have a complete explanation of the phenome- non of rising inflation and slowing growth, and it rests on the role of agricultural output fluctuations, it need not detain us here. The point of recounting this history is to suggest that it is far from clear that the RBI can finetune the inflation rate as is conveyed in the Draft IFC which states that the objective of monetary policy in India should be "price stability", in the context to be understood as a stable inflation rate.
However, let us set aside our scepticism and assume that a Central bank can control the inflation rate. Would inflation targeting be desirable now? We can best answer this by looking at recent experience in the United States. For a decade from the mid-1990s, the inflation rate there had been low and steady, eliciting the epithet "the Great Moderation". But this phase had masked the brewing of a financial crisis in the form of an asset bubble, responsibility for which American commentators trace to the Federal Reserve that had, in view of the low inflation, maintained unusually low interest rates. A feeding frenzy had followed with credit fuelling house price increases. It is in the nature of inflation targetting that sectoral- price increases are ignored. When the bubble finally burst and house prices collapsed, the banks that had financed their purchase found themselves holding worthless assets.