The Urjit Patel Committee has come out in favour of the Reserve Bank of India moving towards a flexible infl ation targeting system. This approach to monetary policy is a product of the much-criticised "new consensus macroeconomics", a school of thought that is credited with causing the recent global fi nancial crisis. The objectives for monetary policy that the committee suggests are not only theoretically unwarranted, but also unjustifi ed for the current state of evolution of India's financial system.
D M Nachane (
nachane@igidr.ac.in) is currently member, Economic Advisory Council to the prime minister.
The views expressed are personal.
Coming immediately in the wake of the prime minister’s remarks1 at the release of the fourth volume of the Reserve Bank of India’s (RBI) history (17 August 2013), exhorting the RBI (under the high-profile current governor) to revisit the conduct of monetary policy, the appointment of an expert committee, the Urjit Patel Committee (UPC), with this precise mandate, generated a great deal of excitement. Predictably, the much-awaited report (released in January 2014) struck a rather flamboyant note, making several far-reaching suggestions, with long-term import.
While the recommendations (listed in Chapter VI of the report) number well over 40, I will restrict myself only to a few important ones, namely: (i) the general macroeconomic approach of the report, (ii) the adoption of flexible inflation targeting (FIT) as the explicit monetary policy objective, (iii) the choice of the inflation metric, (iv) choice of target rate of inflation, and (v) other miscellaneous issues.
General Macroeconomic Approach
The opening sentence2 of Box II.1 of the UPC makes it amply clear that the theoretical framework of this report closely follows that of its antecedents – the Percy Mistry Committee Report and the Raghuram Rajan Committee Report. This theoretical framework, rooted in the twin hypotheses of rational expectations and continuously clearing efficient markets (and cryptically referred to in the current macroeconomic literature as the “new consensus macroeconomics” (NCM)) stands largely discredited in the post-crisis era (Allington et al 2011; Arestis and Karakitsos 2011; Nachane 2013a). The vertical Phillips curve based on the premise that the non-accelerating inflation rate of unemployment (NAIRU) is invariant with respect to shifts in demand factors has been empirically rejected and in its place has emerged the backward bending Phillips curve, originally postulated by Akerlof et al (2000) and then revived in a slightly different format by Palley (2008).
Similarly not much credence is now attached to concepts like the representative agent and rational expectations. There is realisation that economic theory must make room for heterogeneous agents and recognise the limits on an individuals’ rationality imposed by cognitive inabilities to deal with overly complex situations (see the collection of articles in Tesfatsion and Judd 2006 and Caballero 2010). There are many other facets of NCM which have come under very heavy criticism, but I have focused only on those aspects of immediate relevance to policy. But even this brief discussion should suffice to draw attention to the fact that the theoretical framework espoused by the UPC report has been under question for the last several years and its analytical inadequacies and policy effeteness were particularly evident during the recent global crisis.
Flexible Inflation Targeting
The opening remarks of the UPC report seem to point to a fairly balanced approach, and almost leads one to expect that it would favour a monetary policy moving away from a “narrow focus on inflation towards a multiple targets-multiple-indicators approach” (see para II.3). However, the theoretical framework (NCM) espoused by the UPC drives it inexorably to the FIT framework (i e, one where the inflation target is expected to be maintained on the average over the business cycle). By and large, the empirical evidence does indicate that inflation-targeting regimes are successful in their avowed purpose of moderating commodity inflation and tempering its volatility (see Agenor and da Silva 2013, box 3, pp 32-34 for a summary of the latest evidence in this regard). But this, of itself, does not constitute an unqualified criterion for success. There is an abundant theoretical literature supported by adequate econometric evidence that FIT-type regimes could have an unfavourable impact on several other macroeconomic dimensions of direct/indirect significance for social welfare. We briefly discuss only three of these below.
(1) Nominal Exchange Rate: Under a pristine FIT regime, the exchange rate should be left freely floating. However, in most emerging market economies (EMEs) such an option is precluded on pragmatic grounds, as the exchange rate is an important channel of monetary transmission. However, while a dejure floating regime with de facto managed features retains appeal as a workable arrangement, it has to be remembered that in a globally integrated open economy with extensive external commercial borrowings, the exchange rate can move idiosyncratically out of sync with domestic price movements. Imagine the strain on central bank credibility; if in a situation of inflation above the central bank target, it is forced to lower interest rates to cap an exchange rate appreciation (due to an exogenous influx of foreign inflows occasioned by a global liquidity surge).3
(2) Fiscal Dominance: FIT regimes are likely to run into fiscal roadblocks, if public debt (as a proportion of the gross domestic product (GDP)) is high. The logic of this fiscal dominance operates through the so-called risk premium channel (Blanchard 2005), wherein a high interest rate burden on public debt imposed by an inflation-anxious central bank could raise the sovereign risk premium and in extreme cases even lead to capital outflows. A freely floating exchange rate (a necessary adjunct to a FIT regime) could then depreciate sharply, frustrating the very objective of inflation control. That this is not a pure academic point is illustrated by the Brazilian case surrounding the period of the 2002 crisis, documented by Zoli (2005). At this time Brazil was on an inflation-targeting regime and its public debt stood at 79.8% of the GDP. While the corresponding figure currently (2012) stands around 67.6% for India, which may well be considered safe, it is advisable that the public debt profile is kept in mind before embarking on a FIT regime.
(3) Asset Prices and Fragility: The FIT regime does not explicitly regard asset prices as an issue that should concern monetary policy, in the belief that price stability and financial stability are highly complementary and mutually consistent objectives for a central bank (the so-called Jackson Hole Consensus). The global crisis brought out the fatal flaw in this consensus, and gradually prompted an academic shift of opinion to an alternative viewpoint, which argued for a less benign relationship between monetary and financial stability. The essence of this alternative viewpoint (Borio 2011; Bean 2004 and others) sees not only monetary stability coexisting with financial instability, but occasionally also a causal nexus from the former to the latter.
Periods of monetary stability (such as the so-called Great Moderation spanning the decade and a half from 1990 to 2007) are often accompanied by output growth and generate bullish expectations of future prospects. These, in turn, lay the foundations for booms especially in equity markets and real estate. Central banks under FIT regimes (exclusively focused on commodity market inflation) may keep interest rates low, stimulating high risk speculative investment. This sets the stage for the kind of asset price booms which have preceded many crisis episodes including those of 1893, 1907, the Great Depression (1929-33), the Asian Crisis of 1997-98, and of course the current global crisis beginning with the Lehman collapse of 2007. As this alternative viewpoint gained increasing ground in the post-crisis years, a loose consensus seems to have built up around the desirability of a monetary policy responsive to asset prices, though the issue of whether these prices should be used as targets or merely asindicators still remains an open one (Akram and Eitrheim 2008; Lo 2010; Nachane 2014, etc).
The Inflation Metric
Almost universally, inflation-targeting countries have opted for the consumer price index (CPI) as a metric for inflation, as it proxies an ideal cost-of-living index (COLI). In India, the wholesale price index (WPI) (essentially a producers’ price index) has been the preferred official choice for measuring headline inflation. The report proposes to move in line with international practice and adopt the new CPI-combined index being officially published since October 2013. There are however two major problems with the CPI as compared to other indices. We note these below.
(1) The Plutocratic Bias:In a major study for the US, the Boskin Commission (Boskin et al 1996) identified a plethora of problems with the use of the CPI as a measure of COLI. First there is the upper-level substitution bias arising from substitution among different items in the consumption basket identified for the CPI over time.4 Second, there is alower-level substitution bias arising from the way elementary price quotations are aggregated over geographical zones.
But perhaps most important, among the CPI biases, is the plutocratic bias (noted first by Prais 1958, also see Ruiz-Castillo et al 1999 and Ley 2001 for modern treatments and an econometric method for estimating this bias empirically). As is well known, the CPI represents a weighted average of individual household price indexes, with the weights being each household’s total expenditure. Such an index may be termed as a plutocratic index. If instead each household is given equal weight, we get the so-called democratic price index. The plutocratic bias is simply the difference of these two indices, and is essentially dependent on (i) differences in expenditures across different households and (ii) differences in the behaviour among different prices. Estimates of this bias are available for Spain (Ruiz-Castillo et al 1999) and for the US (Deaton 1998). The extent of the plutocratic bias can be judged from the fact that for Spain the representative consumer (i e, whose consumption pattern is closest to the implied CPI weights) is in the 61st percentile, while for the US he/she is in the 75th percentile.5
(2) Terms of Trade Shocks: The financialisation of global commodity markets has meant an increased volatility in commodity prices of fuel and base metals. Trade theory teaches us that unfavourable (favourable) terms of trade shocks are best accommodated via depreciating (appreciating) the exchange rate. CPI-targeting economies would respond to the perceived rise in COLI via an increase in interest rate, reducing the current account deficit (via capital inflows) and leading to exchange rate appreciation, amplifying the consequences of the unfavourable terms of trade shock. As shown in Frankel J (2011), a producers’ price index (based on the prices of goods produced domestically), by comparison, may respond much less to a terms of trade shock (i e, only via second-round effects), thus eliciting a more muted response from the central bank and lower exchange rate appreciation.6
Choice of the Target
The UPC settles on a target rate of inflation of 4% with a tolerance band of 2%. In the absence of any visible evidence to the contrary, I am presuming this result is based on the econometric validation of the dynamic stochastic general equilibrium (DSGE) model in Box II.1, in which case the concerns expressed on “the deflationary bias” and “external shocks” (RBI 2014: 63) seem like ad hoc supplements. An overt commitment to the NAIRU hypothesis rules out any systematic trade-off between inflation and growth, which of course leaves the choice of the target inflation rate in limbo. Bernanke’s (2004) OLIR (optimum long-run inflation rate) as the long-run rate that achieves the best average economic performance over time with respect to both the inflation and output objectives, is not of much help either. One sincerely wishes that the committee had delved deeper into this question.
Miscellanea
Recommendation 7 of the UPC report (p 63) identifies administered setting of prices and wages as significant impediments to monetary policy transmission, but in all fairness should have admitted that the rapid growth of securitisation and shadow banking are equally great (or even greater) impediments. While the enhanced status of the Monetary Policy Committee (MPC) (RBI 2014: 64) would have been understandable under the current operating framework, it is not clear what such an MPC would achieve under a FIT regime guided by a Taylor-type rule, where the monetary policy stance is largely predetermined. Instead such an MPC could easily become a battleground for competing stakeholders in the financial system. Finally (on p 67) the UPC report insists that the “Government should eschew suasion and directives to banks on interest rates that run counter to monetary policy actions”. With this I am in complete agreement.
Conclusions
The UPC has come out very strongly in favour of the RBI moving towards a FIT regime. I have tried to argue that the case for such a regime is neither warranted on theoretical grounds nor justified by the current state of evolution of the country’s financial system. This, of course, is not to say that the current system is perfect and needs no change, or that inflation is not an important issue for the economy.
In my assessment the drawbacks in the current system spring not so much from the choice of objectives as from the operating procedures, and over-dependence on a theoretical framework (the NCM) whose limitations have already become amply evident with the recent crisis.7 The UPC, while persisting with this framework, simply takes it to its logical policy extremity.
