The Hindu Business Line : A case against inflation targeting

As long as monetary policy transmission channels remain weak and too many domestic prices are administered by the Government, it would be ill-advised to go in for inflation targeting as it would expose the RBI’s lack of complete control over the economy, says RUDRA SENSARMA.

The Raghuram Rajan Committee’s report on financial sector reforms has generated a lot of interest. While the committee has made several useful recommendations on micro aspects of financial sector policy, the one aspect that seems to have attracted popular attention is whether the RBI should adopt the principle of inflation targeting.

While the committee recommends that this framework be adopted when the time is right, that is, when inflation is low, it is ironical that the issue is being widely debated now when inflation is shooting through the roof.

Be that as it may, the intent here is to clarify some issues that are getting obfuscated in this passionate debate over the merits and demerits of inflation targeting.

Indian angle

Does India need an inflation targeting monetary policy framework? In recommending this framework, the Rajan Committee suggests that the RBI adopt a single monetary policy tool (such as the repo or the reverse repo ) and a single objective (inflation). Inflation has many costs. High inflation leads to delayed investment decisions and increased borrowing costs as lenders start charging a premium on account of higher prices.

A regime of galloping prices generates uncertainty about the business environment forcing some investors to shift to safe assets which affects firms’ borrowing plans. In such cases, an inflation targeting framework does offer benefits in terms of lowering uncertainty by controlling the price rise and, thereby, helping improve business productivity.

However, the fact that multiple tools and objectives (which the RBI adopts at present) can confuse markets does not automatically mean that an inflation targeting framework is the alternative. It is not yet clear whether the RBI has any control over inflation which is a prerequisite for adopting inflation targeting.

Issues of whether inflation in India is demand or supply driven, domestic or imported are far from resolved. Evidence suggests that we are now witnessing a combination of these factors. The past few years have witnessed explosive monetary growth that has contributed to today’s inflation.

While this is something in the RBI’ ambit, more recently we have been hit by high oil prices, which the apex bank has little control over. In an inflation targeting regime, the RBI can fight domestic and demand-pull inflation by increasing interest rates and also address imported inflation by allowing the rupee to appreciate.

But this will not work to the full extent as long as monetary policy transmission channels remain weak and too many domestic prices are administered by the Government.

The policymakers have to first define and then attain some preconditions, such as clarity, credibility and effectiveness of monetary policy, dismantling of administered price mechanisms and developing timely, comprehensive and high frequency measures of inflation.

Till that time, it would be dangerous to shift to an inflation targeting framework as it would expose the RBI’s lack of complete control over the economy. Moreover, the Government has several tools for fighting supply-side inflation (example, taxes, trade policy, administered prices) which an inflation targeting framework precludes.

Is low inflation a must?

It is not yet very clear whether lower inflation is indeed the preferred policy objective if it leads to sacrifice of economic growth in a developing economy like India. Unlike in a developed, full-employment economy where inflation hurts by taxing the poor who are largely the so-called working classes, in India the unemployed poor may sometimes prefer the dignity of having a job and pay higher bills than to not having a job at all.

The Rajan Committee suggests that there is no conflict between inflation targeting and growth but recent experience even in developed economies suggests otherwise.

In the past few months, the Bank of England has effectively abandoned its inflation target as it focuses on reviving a sagging economy. The cases of the European Central Bank and many other inflation targeting countries are no different. It is indeed ironical that we are thinking of adopting inflation targeting when other countries, especially those facing economic slowdown, are ignoring their inflation targets and focusing on growth (including the pioneer of inflation targeting, the Reserve Bank of New Zealand!).

In sum, inflation targeting has several pluses but the jury is still out on whether they outnumber the minuses. Till the time the net benefits are clear, it may be pre-mature to implement this framework in the Indian scenario.

Exchange rate targeting

Commentators have criticised the RBI for targeting the exchange rate when it should have focused on low inflation. While the usual reference to the impossible trinity (capital mobility, fixed exchange rates and interest rate autonomy) is tempting, it is important to remember that while it is impossible to control too many things at the same time, the RBI keeps shifting its focus among competing objectives simply because that is its job.

The RBI has to follow its complex mandate of pursuing growth with stability using all policy tools at its disposal. This principle is not too different from what some leading central banks such as the US Federal Reserve follow. Yes, the RBI could exit from the forex market (and stop supporting export-led growth) and focus on inflation. But for that the Government has to first decide if that is the preferred policy choice and, accordingly, change the RBI’s mandate.

But as mentioned, this issue of identifying the preferred objective needs to be resolved first. Is low inflation-low growth preferable to high inflation-high growth or can we tolerate some inflation while enjoying growth?

When high growth and high inflation go hand in hand, the RBI has to be clear about what is the threshold level of inflation beyond which the devil of inflationary expectations kick in and growth and productivity are affected.

At that stage the RBI should actively deploy all its policy instruments (as indeed it seems to be doing right now). At the same time, the Government should pitch in with its supply-side arsenal. If this combined strategy can be implemented judiciously, inflation targeting may not be necessary.

Central bank autonomy

Some commentators have argued that one of the benefits of inflation targeting is that it will lead to an independent RBI, as setting a rule-based objective makes the central bank immune from political interference. But do we really need an independent RBI? And, is an independent RBI possible? No. Even a change in statute will not work as long as key appointments are controlled by the Finance Ministry and RBI governors get to take up future jobs with the Government. But then, should the RBI have autonomy when it does not face the electorate?

It may be better for the RBI to be given a politically determined objective by the Government (for example, high growth or low inflation depending on the priority or even a combination of the two objectives through what is known as the Taylor rule of monetary policy) along with operational autonomy to pursue its objective. The RBI may argue that this is what already exists implicitly, but then that needs to be explicitly acknowledged. Lack of communication may be creating all the confusion.

Therefore, unless we are convinced that we need a fully independent RBI, how can we argue that inflation targeting is a good way of having an independent RBI? That would be akin to putting the cart before the horse.

Lessons from abroad

Recent history of the global financial system suggests that many policies that sounded good in theory and looked good in boom-time did not stand the stress tests of crises.

The UK Government’s initiative of separating bank supervision from monetary policy was hailed as a role model in financial sector reforms till the Northern Rock bank fiasco exposed the weaknesses of the arrangement.

The developed world lectured us on the demerits of public ownership of banks but the Bank of England promptly nationalised Northern Rock when it collapsed. More recently, the US Fed lost no time in bailing out a collapsing Bear Sterns when all this while we were warned about the dangers of moral hazard in such bailouts.

Likewise when central banks across the globe are abandoning their inflation targeting frameworks, extreme caution is called for while pursuing this policy. It is better to err on the side of caution, especially when it comes to public policy.

(The author is Senior Lecturer in Finance, University of Hertfordshire Business School, UK. Responses to blfeedback@thehindu.co.in)

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