The RBI and the government have decided to adopt the discredited policy of inflation targeting.
With a missionary zeal, the Reserve Bank of India (RBI) and the government have pushed ahead with inflation targeting as the core of future monetary policy. An agreement on a monetary policy framework has been signed, committing the RBI to bring inflation below 6% by January 2016 and a target of 4% with a band of +/- 2% for 2016–17 and all subsequent years.
For some time now, the RBI has been explicitly working towards this goal of inflation targeting. Various committees like the 2008 Committee on Financial Sector Reforms (constituted by the Planning Commission with the current Governor of RBI Raghuram Rajan as chairman) and the 2013 Financial Sector Legislative Reforms Commission spoke in its favour. Initially it appeared that the RBI was against adopting any inflation targeting framework and, in fact, the then RBI Governor D Subbarao spoke, in 2011, eloquently delineating the central bank’s position. With Raghuram Rajan becoming the Governor of RBI and the emergence of a single Consumer Price Index (CPI) to track inflation, the decks were cleared for a 180 degree turn in the RBI’s position. Subsequently, following the recommendations of the Committee to Revise and Strengthen the Monetary Policy Framework, with RBI Deputy Governor Urjit Patel as chairman, inflation targeting became synonymous with “a strong, transparent, predictable and effective monetary policy framework (that) is needed to deliver low inflation.”
Apart from the change in personalities at the top, what could have prompted the RBI to change its stance? Is it the intention to follow global practices? Or is it an endeavour to gain credibility and independence for the central bank? Or is this seen as the optimal solution for putting an end to the turf war between the fiscal and monetary policies/authorities? One can only speculate on the reasons. Curiously, India adopts inflation targeting after a global bandwagon in this direction that was stopped in its tracks by the global financial crisis of 2007–08. If inflation targeting was the goal of many central banks before the crisis, it was subsequently debunked because, with its neglect of asset prices and obsession with low inflation, it did not anticipate the global crisis and therefore failed to take corrective measures in advance. With inflation targeting there could be an asymmetry in the central bank’s dealing with asset price inflation. When asset prices go up, central banks which adopt inflation targeting tend to neglect them, but at the time of a slide in asset prices they may be compelled to act.
In the Indian case one can cite a number of reasons why the adoption of inflation targeting as a monetary policy framework could be inappropriate. First, the monetary policymaker cannot escape the reality of an inflation–output trade-off in the short run. India’s central bank is compelled to take care of multiple objectives. In India, the exchange rate and portfolio flows have shared the centre stage with growth in the formulation of monetary policy. After all, despite the so-called impossible trinity, the Indian and Chinese experiences both amply illustrate that a country can achieve non-corner solutions, whereby the central bank can have a combination of some monetary policy independence coupled with limited capital account convertibility and partially-managed exchange rates. Second, the Indian framework on inflation targeting is couched in terms of overall CPI inflation, but the presence of substantial inflation in food and fuel makes inflation in India less amenable to monetary policy actions; the proposed inflation targeting framework does not talk of some sort of “core inflation” that is free from all such influences of external factors/administered prices. Third, in a country where any announcement of a fall in monetary policy rates is invariably followed by moral suasion of commercial banks to cut lending rates, the efficacy of monetary transmission is seriously in question and hence one is never sure of the effectiveness of inflation targeting. Finally, as the new framework does not talk of the composition of the Monetary Policy Committee (MPC) that is to oversee targeting, one does not have sufficient clarity as to how it will function. Would the Governor of the RBI have veto power? Will there be two representatives from the Ministry of Finance? Will the voting be published by names of the MPC members? All such questions remain unanswered.
In the end, the adoption of inflation targeting does mean a certain degree of monetary fundamentalism — simultaneously negating the role of cost-push factors in driving inflation. Inflation targeting essentially looks at inflation solely as a phenomenon of excess demand and tries to tame it with interest rate policies. As a cornerstone of the existing mainstream economics paradigm (often euphemistically called the new consensus macroeconomics), which was discredited during the global financial crisis, the inflation targeting framework pushes fiscal policy to the background and brings monetary policy to the forefront. This could have serious consequences in a country like India. Illustratively, the RBI Annual Report for 2013–14 identifies factors such as, “implementation of the MGNREGA [Mahatma Gandhi National Rural Employment Guarantee Act] and its indexation to the CPI for Agricultural Labourers (AL) and, falling labour force participation rates in particular for women,” as responsible for an increase in rural wages that led to inflation, and goes on to comment, “While the increase in wages could be desirable from a social welfare point of view, wage increases in excess of productivity growth lead to a wage price spiral and make food inflation a self perpetuating cycle.” Against such a backdrop, one must be apprehensive about whether adoption of inflation targeting adds fuel to the demand to wind up MGNREGA, all the more so when Prime Minister Narendra Modi spoke so insensitively and strongly against the scheme in Parliament.
One is not sure about the appropriateness of the inflation targeting framework for India at the current juncture. The framework that is being adopted raises more questions — both technically and administratively — than it answers. It is far from clear how the central bank and the finance ministry are going to resolve these issues. Until then, we must be hostage to some economic policy of questionable fundamentals.
