The RBI Governor should think twice before pegging the target rate of inflation at a higher level and calling that the ‘new normal’. There is no basis to the argument.

The Indian economy posted a GDP growth of 5.3 per cent in the second quarter of 2012-13 on a year-on-year basis. This is against the 6.7 per cent GDP growth achieved in the corresponding period last year.

Combined with the first-quarter growth of 5.5 per cent, growth in the first half of 2012-13 has turned out to be 5.4 per cent. If India is to grow at 5.8 per cent, in 2012-13, as per the RBI’s revised projections, growth has to scale up to 6.2 per cent in the second half. Can we get anywhere near that?

The answer would depend on how the challenges on the monetary and fiscal front are addressed by the government and the central bank, respectively.

If one traces the Indian economy’s downhill journey in the past two years, it becomes apparent that governance-related issues coupled with policy stasis have contributed to most of the problems in the real sector. A hawkish monetary stance has contributed its bit as well.

The government initiated a spate of measures in September to dispel the gloom, and it is hoped that the economy will do much better in the second half. However, the reform measures announced in September are exposed to implementation risks.

Behind the Curve

The Reserve Bank Governor D. Subbarao provided a guidance to the market on possible rate easing in January 2013.

The RBI is already way behind the curve, as far as the timing of easing of rates is concerned. Since the growth sacrifice has been much more than what the RBI had in mind, it may ease policy rates on December 18, when the mid-quarter review of monetary policy is due, instead of waiting further.

The RBI may issue a guidance on its inflation target in the mid-quarter review. At the silver jubilee function of Indira Gandhi Institute of Development Research, the RBI Governor agreed to revisit the acceptable level of inflation or, in other words, the inflation target.

The supposed basis for revisiting the inflation target is: structural rigidities in the system, fiscal profligacy and slack in the global economy.

To many, the RBI is too ambitious on the inflation front, given the price dynamics of the past three years. Hence, the call for a higher inflation target.

‘New Normal’ Inflation

The issue is whether it is a good idea to think of a ‘new normal’ for inflation.

To change the desired level of inflation is tantamount to changing the ends to justify the means.

What is the end that monetary policy tries to serve? It is a mix of reasonable growth and tolerable inflation through calibration of policy rates and liquidity. The means adopted have, however, often been at variance with the price stability objective.

For instance, by reducing CRR in September when the liquidity position was comfortable, the RBI ignored the potential inflationary consequences of its policy.

Despite 13 policy hikes between March 2010 and November 2011, and elevated policy rates till April 2012, inflation is still in the 6-8 per cent range, above the medium-term inflation target of 4-5 per cent. The rate hikes helped to soften inflation from 8-10 per cent, seen a year back, to the current 6-8 per cent. Even that is not good enough.

What’s worse, in the process, growth has slumped from 8-9 per cent to 5-6 per cent. Since a tight monetary policy for an extended period did not bring down inflation to the desired levels and instead pegged back growth, there is a call from some quarters to change the goal itself, i.e., relax the inflation target by pegging it at a higher level.

The argument offered in favour of this approach is that sticking to an artificially low inflation target is leading to a tighter monetary stance, stifling growth.

By targeting a higher level of inflation, the RBI will have the elbow room to lower policy rates more aggressively, and hence support growth.

However, if the RBI feels it should tilt its policy towards monetary easing, it can do so without changing the inflation target.

Rate easing, coupled with reform initiatives, might improve the supply response and curb inflationary pressures.

Other options

However, if the RBI does come up with a ‘new normal’ for inflation, it would be contradicting its avowed stance that high inflation is inimical to the growth process. India is looking at a medium term growth rate of 7-8 per cent.

On a more theoretical note, the various reform measures initiated should ease rigidities in the system and improve the supply response. With the easing of supply side constraints, the inflation target should trend downwards, rather than move upwards.

Finally, changing the inflation target in a democracy has its own dangers.

(The Author is Associate Dean, Xavier Institute of Management, Bhubaneswar. The views are personal.)

(This article was published on December 6, 2012)
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