Inflation targeting makes no sense

It has been close to two years since the Urjit Patel Committee report set CPI-based ‘inflation targeting’ as the primary axis of our monetary policy. There are murmurs now from both the vice-chairman of Niti Aayog and the chief economic advisor.

In both its key thrusts — abandoning the multiple indicator approach for inflation control and adopting CPI combined instead of WPI as the inflation to target — it is like a cricket umpire trying to control a football game in an adjacent ground.With the benefit of hindsight, it seems out of context and tautological in its key arguments and conclusions.

For instance, when it states: “Anchored inflation expectations will … provide the latitude to address other objectives without compromising price stability” . In 18 months, the RBI has not been able to even ‘anchor’ interest rate expectations — there is so much debate before each meeting and annoyance after. To anchor inflation expectation by stabilising inflation; to provide a stable interest rate regime to create ideal conditions for investments to generate employment and growth; … by the time this comes about it may be Saturday in Solomon Grundy’s economic life cycle.

“High inflation expectations exhibit far greater stickiness than inflation” (para 3.2). In the past 5-6 years, most of the inflation has come from agricultural commodities and fuel, segments least under the RBI’s control.

Our agricultural markets are the most ‘perfect’ and given the Indian mindset of ‘bargain everything’, prices quickly readjust to imbalances. If onion prices ruled at ₹80 one week and slid to ₹20 the next two weeks, it is inconceivable that anyone’s expectations would be guided by prices that prevailed three weeks earlier. The reverse is also true. Trying to stabilise them through interest rates is a fruitless exercise.

The level of emphasis to be given to inflation control should ideally depend on the national ‘wealth to current income’ ratio. Where it is high and more citizens depend on interest from savings for livelihood, preservation of the money’s value is more important. India’s ratio will be dismal comparatively, and hence the need to balance it with growth and employment objectives. In our context, jobs are the best social security.

The targets set are a source of worry, for growth itself can cause inflation. For example, in a 2-product, 2-player economy producing 4 coconuts and 2 fish, each fish will retail for 2 coconuts. If the productivity of coconuts increases to 6, the price of fish will become 3. In a monetised economy, wages are terribly sticky downwards and the price of coconuts (derived from the wages which do not move downwards) will remain the same and the price of fish will move up by 50 per cent.

There will be the inevitable inflation even if the weights are corrected. However, this is harmless inflation. Suppressing this will only result in curbing growth.

A constant inflation target of 6 per cent (plus/minus 2 per cent), irrespective of whether the growth is 4.5 per cent or 8 per cent, seems meaningless. Given India’s rigidities and the way minimum wages are revised whimsically, a 6 per cent target may be far too constraining for an 8 per cent growth target.

In a place like Singapore where trade credits are almost entirely from the banking system, and firms are leveraged 3 or 4 times and work on thin net margins of 2 per cent, a quarter per cent hike is a huge dampener, and firms may start cutting down on stocks from the next cycle itself.

In India with 10-12 per cent gross retail margins, and credit largely accessed from non-banking sources, a 0.25 per cent interest rate adjustment to tame or stoke inflation seems irrelevant. Large dosages to achieve a given reduction in overall inflation will hurt a whole host of other sectors disproportionately.

The report relies on the New Keynesian Philips Curve equation as the theoretical framework. The three factors listed (output gap, cost push, and expectations) in the supply block of the equation, while relevant, are far from decisive or comprehensive. Let’s look at an example — how ‘cost push’ can be highly episodic or fickle.

The supply curve is the marginal costs of various firms stacked in increasing order from most efficient to most inefficient and the price is determined purely by the marginal cost of the most inefficient firm required to fulfil a given level of demand. The cost structure of all the other more efficient firms is irrelevant.

Where the most marginal supplier unit (which determines the price) happens to be an overseas firm, prices will be purely determined by import parity. Domestic cost structures do not matter at all: what will matter is the cost structure of source countries. In such a case, currency movements play a much larger role.

Again, where the marginal cost difference between the least competitive firm and the next is low or negligible, output gaps may not have an impact on inflation at all.

One does not know how one can effect inflation targeting policies on such highly fickle variables.

The report justifies targeting since “persistent inflation worsens income distribution as the poor carry greater proportion of cash”. This is spurious sympathy. The poor carry cash largely for transaction demand. In rural areas, savings till the next season is largely by way of grains and over the longer term in gold. Surplus cash in the informal sector finds its way usually into small, unorganised chit funds and informal credits earning 5-6 per cent per month. It is impossible to conceive that they carry cash over the longer time as savings. A cash balance of two months when inflation is 12 per cent per annum suffers 2 per cent value dilution. This is just 1 per cent higher than at the targeted inflation levels — hardly relevant, which only shows a lack of contextual knowledge.

Inflation in a way represents the existence of consumer surplus. In the initial wave, it’s only products with high consumer surplus that will move up in price.

There is no reason for the RBI to be an arbiter in such a case. It is only in the secondary wave that the prices of others will move up before it becomes a monetary phenomenon. If those affected in the secondary wave are interest rate sensitive, then to target inflation with interest rates becomes logical — but only if.

Any regulator will have to keep the aspirations of the people in mind. Ask any jobseeker whether he would prefer a job or live with an additional 5-6 per cent inflation. Employment will most certainly be preferable to preservation of value. Growth expands employment opportunities. To be dismissive of these and concentrate on CPI-based inflation is to forget the context.

The writer is the author of ‘Making Growth Happen in India’

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