RBI go­ing be­yond in­fla­tion tar­get­ing

The Pak Banker - - OPINION - Pu­lapre Balakr­ish­nan

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.

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