The Hindu Business Line : Departure from inflation-targeting

With the Indian economy undergoing rapid structural changes since the 1990s, the notion of the threshold rate of inflation must be revisited every five years.

A. Srinivas

The Reserve Bank of India’s moves to spur the economy through repeated cash reserve ratio and repo rate cuts are all very well. But one wished it explain the current turbulence by providing more theoretical insight and perspective, going beyond a short-term, policy-oriented approach. For instance, the relationship between the financial sector and the ‘real’ economy is a burning issue, yet the current global discourse is too focused on regulation and gove rnance to capture broader trends — and the RBI is no exception.

The central bank’s economy reviews should explore the current debates and academic literature, so that people understand the backdrop against which it makes its observations. A theoretical approach would also be useful while explaining the trade-off between inflation and growth. Inflation targets would not seem as though they have been plucked out of thin air.

In this sense, the RBI’s Mid-Term Review of the annual Credit Policy for 2008-09 is a disappointment. It does not explain why it considers 5 per cent inflation an acceptable target in the short-term and 3 per cent in the medium-term, as opposed to any other set of figures. That said, the review is categorical about pursuing a number of objectives, as opposed to targeting-inflation alone, thereby differing from the approach spelt out in the Raghuram Rajan Committee report.

MEASURING INFLATION

On inflation, the review says that it “it will be the Reserve Bank’s endeavour to bring down inflation to a tolerable level of below 5 per cent at the earliest, while aiming for convergence with the global average of around 3 per cent over the medium term”. Why these numbers? A threshold rate of inflation is a level beyond which it becomes growth-retarding rather than beneficial to output and employment.

The Sukhamoy Chakroborty committee in 1985 had pegged the threshold rate of inflation at 4 per cent. A decade later, the then RBI Governor, Dr C. Rangarajan, put the level at around 6 per cent. What is the threshold level of inflation at present is anyone’s guess, as the RBI has not examined this issue in recent years. With the Indian economy undergoing rapid structural changes since the 1990s, the notion of the threshold rate of inflation must be revisited every five years.

This should be accompanied by sharper indices to measure price rise. The wholesale price index should not only represent all the goods and services available in the country, but also ensure that their prices are accurately recorded through sampling methods that are revised from time to time.

Similarly, core inflation, consisting of non-volatile elements, should be separated from headline inflation, which consists of food and energy prices that are prone to short-term fluctuations. To get a fix on inflation, the RBI and the North Block should be clear on a separate threshold level for core and headline inflation. An inflation figure for 1,224 disparate goods and services, against 435 at present, would not mean much.

MULTIPLE OBJECTIVES

Should the RBI only target inflation or also seek to control asset prices before they turn into bubbles? The former Governor, Dr Y. V. Reddy, indicated his preference for a “multi-disciplinary approach”. Under him, the RBI contained a property bubble by increasing the risk weightage for real-estate lending in 2006.

The Mid-Term Review reflects a continuation of this approach, saying: “The task of monetary management has always centred around managing a judicious balance between price stability, sustaining the growth momentum and maintaining financial stability…The global financial turmoil has, however, reinforced the importance of putting special emphasis on preserving financial stability.”

The Raghuram Rajan Committee on financial sector reforms has advocated inflation-targeting, to the virtual exclusion of other objectives. In the wake of the financial crisis, this approach has come under scrutiny in academic and policymaking circles in the US and Europe. The RBI’s position marks a departure from the Greenspan-Bernanke line.

Attacking the inflation-targeting approach, Paul De Grauwe of the University of Leuven and CEPR says in a paper, “Banks were heavily implicated both in the development of the bubble in the housing markets and in its subsequent crash...Some may wish that central banks would abstain from supplying this insurance. Economic theory, however, tells us that central banks should intervene to provide liquidity if the liquidity crisis risks disrupting the payments system, hurting many innocent bystanders... It is not reasonable for a central bank to argue that asset bubbles and crashes should not be a source of concern... when it knows that the bubble will have large implications for its future balance sheet...” He disagrees with the Greenspan school, which believes that “the macroeconomic consequences of bubbles and crashes are limited as long as central banks keep inflation on track” and that “the central bank should not target (or try to influence) asset prices”.

The fact that a lot of liquidity creation in relation to the housing bubbles has occurred outside the banking system, while also implicating banks, does not speak favourably of a hands-off approach to asset prices, the paper argues.

A contrary view comes from Katrin Assenmacher-Wesche and Stefan Gerlach of the Swiss National Bank and Johann Wolfgang Goethe University, respectively. In a paper, they argue, “In addition to the fact that the central bank should form a view of whether a particular asset price increase is dangerous or not, it requires monetary policy to have predictable effects on asset prices... The size of interest-rate movements required to prevent a bubble from developing must not be so large as to cause output and inflation to drop substantially below the central bank’s objectives for them.”

Analysing the responses of property and equity prices to monetary policy shocks in 17 OECD countries between 1986 and 2006, they discovered that a 100 basis points’ increase in interest rates leads to 2.6 per cent drop in real property prices over 16 quarters. Real GDP falls by 0.8 per cent over 16 quarters, or a third of property prices. Equity prices fall immediately by 2 per cent, but after 16 quarters are just 0.5 per cent below their initial level.

The paper says that to target asset prices, “the effects of monetary policy on different asset prices must occur at about the same speed...”

Monetary tools

Since property and equity prices react at different speeds, the authors feel that central banks cannot stabilise both. “The idea of using interest rate policy to forestall asset prices bubbles is not practicable”, they conclude, adding that “monetary policy is too blunt an instrument to be used to target asset prices”. This view is close to that of Federal Reserve Chairman, Mr Ben Bernanke.

The RBI should come out with a position paper on the relationship between the ‘real’ and ‘money’ economy, indicating in the process whether asset prices should be monitored as a matter of policy.

At the end of 2005, total financial assets were 3.7 times world gross domestic product. Market capitalisation in India is 150 per cent of GDP, higher than US (128.8 per cent), Japan (104.4 per cent), China (137.3 per cent) and South Korea (116.2 per cent).

While the financial sector helps channelise savings towards investments, generates liquidity and reduces the cost of credit, it can be carried away by its own dynamic, undermining stability in the real economy. What is the threshold level beyond which the growth of financial assets should be considered dangerous, leading to a bubble? There seem to be no yardsticks to guide policy in these areas.

The RBI’s policy statements should reflect the changing global discourse. When the Finance Minister or the RBI Governor expresses faith in financial sector reforms, he should explain what that means in the current scenario. The people have a right to know.

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