The Hindu Business Line : Inflation targeting and India

If the RBI increases interest rates with a view to controlling inflation, it can do so only by slowing down demand, which means growth will be inevitably affected. Many observers point out that this is already happening in the country, says S.VENKITARAMANAN.

The high level of inflation in India, at present raging at 11 per cent plus, is causing flutters in the financial community not only because it represents higher costs but also the fear that the RBI may tighten its interest rate policy further than so far. The logic behind RBI’s tightening interest rates when inflation rises is based on the fact that interest rates are the reward for the saver delaying consumption. The interest rates should not be lower than the rate of inflation; otherwise the real rate of interest will be negative.

Inflation targeting has gained acceptance in various countries of the world, including the US and the UK as well as the European Central Bank (ECB). The latest advocate of inflation targeting in India is the Raghuram Rajan Committee on Financial Structure Reforms.

Reform recommendations

In a well-studied report, this High Powered Committee made a series of recommendations. It covers a variety of areas including regulation and aspects of policy, such as inclusion. In fact, it has found acceptance for most of its proposals based on the masterly analysis of the Indian financial situation by its expert members.

A well-known and experienced economist, Dr Shankar Acharya, had, in an article in the Economic and Political Weekly, stated that the Committee has been curiously academic and set itself aloof from the realities of the Indian macroeconomic setting. He had further stated that the narrow view of macroeconomics adopted by the Committee had led to a surprisingly adventurist recommendation that the RBI should have a single-minded objective of low inflation.

It states: “RBI should primarily have a single policy objective to stay close to a low inflation number or within a range in the medium term and move steadily to a single instrument of short-term interest rates (i.e. repo and reverse repo) to achieve it.” This implies that the recommendations of the Committee conform to the school of thought that believes that the interest rates can be an effective instrument in controlling inflation.

A review article by Rekha Chakraborty in Economic and Political Weekly describes elaborately the fate of similar policies in different countries. It makes reference to earlier reports on the subject of monetary reforms, in particular, to the report of the Sukhamoy Chakraborty Committee, whose recommendations in 1985 were in favour of monetary targeting, but not the simple Friedman rule of expansion by an arbitrary rate every year.

The latest Committee under Raghuram Rajan has, however, made a departure in recommending inflation targeting. But, in so departing from earlier recommendations, it follows the current fashion in developed countries, which has been in favour of inflation targeting.

Weak transmission mechanism

While it is true that tightening of monetary policy, which is implied in inflation targeting, involves high interest rates and other tools decrease liquidity and thus demand, it is difficult to say how tightening of demand can affect price level, such as those of food and fuel, which seem to be determined by international action and governed by monopolist price-setters, such as OPEC.

It has been explained by official spokesmen in recent discussions, following the latest spate of inflation figures, that while it is true that Indian inflation is primarily due to global factors, it remains, nonetheless, valid that tightening demand can make inflation decrease faster than it would otherwise. The validity of this argument has to be tested over time.

This writer, however, estimates that any decline in inflation in India in the coming months will be more a consequence of increasing food arrivals and consequent overall prospects of decreased prices of rice, wheat and coarse grains in the coming few months. This, rather than the result of interest rates tightening, will be the feature of the domestic economic scenario.

But ideology is strong and when a Committee as influential as the Raghuram Rajan Committee recommends a single-minded inflation objective, the RBI cannot be expected to refrain from inflation targeting. The review article in the Economic and Political Weekly points out the significant fact that the transmission mechanism for short-term interest rates in the Indian financial system is weak, unlike in developed markets such as the US, the UK and EU. This reduces the effectiveness of tightening short-term interest rates as a means of communicating the RBI’s policies to the economy. This criticism does not, however, take into account the fact that when the RBI tightens interest rates, demand does fall. This is as a result of banks being quick to follow through by raising their interest rates for housing loans as well as consumer durables and autos. The result of all this is seen as decline in demand.

While the criticism of inflation targeting may be inappropriate in the Indian context, the actual experience suggests that the RBI’s interest rate tightening does have a definite impact of slowing down the economy. The resulting decrease in demand should help decrease inflation to the extent demand plays a part.

Mutually contradictory

What is inconsistent in the approach of inflation targeting with the objective of nurturing growth is that the two goals are mutually contradictory. If the RBI increases interest rates with a view to controlling inflation, it can do so only by slowing down demand, which means growth will be inevitably affected. There are already observers who point out that this is already happening in the country. One cannot blame the RBI for this. If we expect it to target inflation and higher interest rates, it cannot be expected not to slow down the economy.

All this is, however, complicated by the villain of the piece, viz. capital flows into and out of India. As capital flows increase into the country, they have many effects, including, in particular, increase in liquidity and appreciation of the currency. Increase in liquidity is inflationary, but appreciation of the currency is not so.

While inflation targeting and interest rate increases are preferred medicines by the experts such as those of the Raghuram Rajan Committee, they have also an impact that increase in interest rates makes India an attractive destination for capital flows, which makes the whole problem of liquidity and inflation management worse. It leads to higher inflation instead of lower — a case of unpleasant monetary arithmetic of inflation targeting.

Difficult task at hand

On the whole, the RBI has a difficult task on its hand when it comes to announcing its Monetary Policy by the end of this month. The diktats of OPEC seem to be the last word in deciding the policies of even the most independent central bank. It remains to be seen how Governor Reddy handles the complex problem!

Inflation targeting in India is particularly difficult since the RBI is expected to keep in mind growth target also. Further, as pointed out, the transmission mechanism from short-term rates to the financial system is flawed. Inflation targeting as such may be difficult, but Governor Reddy will be ready to tighten interest rates and liquidity through a variety of tools.

How it will all pass through in terms of inflation figures depends on the vagaries of Saudi Arabia and the monsoons more than on his own policies. But the RBI has to do its job and cannot be denied the freedom to set higher rates on repo and reverse repo. All the time, the bank has to keep an eye on the economy’s growth rate. A difficult task; but who said the job of the central bank Governor is easy?