Inflation targeting of the wrong kind

One major proposal included in the Union Budget for 2015-16 that has an impact on the working of the Reserve Bank of India (RBI) relates to inflation targeting. It has been debated for quite some time and now that the decision has been taken, it is important that the implication is examined before the government proceeds further in the matter.

It is not as if we do not have an inflation target now. In the RBI’s periodical policy reviews of the past there has been a formal declaration of the objective of keeping the rate around 5 per cent. There was also a statement that the medium-term target would be 3 per cent.

Inflation targeting would only mean that the objective would be written into law, unlike now, resulting in certain consequences, if it is not realised. The success of targeting would very much depend on the autonomy of the central bank in pursuing its goal and the government’s control of fiscal and current account deficits.

From the fixing of inflation target at 4 plus or minus 2 per cent it seems that 6 per cent is the new normal for price rise, against 5 per cent accepted for a long time. While the upper limit is understandable, it is not clear why there is a lower limit.

This is perhaps a case of the blind copying of the manner in which the target has been fixed in the developed countries. In those countries, deflation is as much dreaded as inflation from the point of view of unemployment; the measures available to deal with the former are not as effective as those for tackling the latter, as we have seen in the case of Japan. As the saying goes, you can pull but not push a string.

In the Indian context deflation is as welcome as disinflation considering the high levels to which prices have risen, whether it is goods and services or assets such as real estate.

Any absolute reduction in prices will increase demand by the movement of the demand to a higher point on the demand curve stimulating growth. In the recent period, fruits and vegetables have been the main source driving the inflationary impulses in the economy.

If there is a steep seasonal price decline, should the RBI engage in an expansionary monetary policy that will have a spillover effect on the non-food sectors or should it only point out the reason for the decline in the report it is expected to submit to the government?

So far as major foodgrains are concerned, there is the system of minimum support prices. Government agencies are ready to procure an unlimited amount from farmers even if the market prices do not fall. Any fall that may contribute to the general inflation level falling below 2 per cent would not affect them. Instead it will help them spend more on non-food items such as clothing.

On the manufacturing side, the need is for cost-cutting measures through R&D. Entrepreneurs have been content with asking for relief from government in taxation or depreciation of the rupee without any effort in undertaking research to increase productivity.

The preamble to the RBI Act refers to ‘monetary stability’ as the objective for the bank. The Chakravarty Committee Report on the working of the Monetary System (CCRMS) brought about a new paradigm in the objective of monetary policy and its implementation. It redefined the objective without saying so overtly to provide for an “acceptable” or “tolerable” inflation rate of 4 per cent. This would reflect the general price rise resulting from changing relative prices.

I have questioned this rationale and described its damaging consequences in various articles on the subject. Since the Chakravarty Committee’s report was accepted, the “tolerable rate” has become 5 per cent and there was also talk among the policymakers of a “new normal” of 6 to 6.5 per cent.

Until the acceptance of the report in the mid-1980s, monetary stability was interpreted to mean price stability or stability in the purchasing power of the rupee as could be inferred from the official documents of both the RBI and the government. There was then a quiet and pernicious shift to the interpretation of the objective to imply the stability of the inflation rate. A 5 per cent inflation rate was also built into the RBI estimates of desirable money supply, thus assuring the economy of a minimum inflation of that magnitude.

Underlying the shift was the wrong assumption that a moderate inflation would contribute to growth. There was no discussion in Parliament of such a fundamental change in the objective of monetary management. Would the inflation target of 4 plus/minus 2 per cent during three consecutive quarters meet the criterion of monetary stability? Either the preamble should be suitably amended to incorporate the inflation target or the term ‘monetary stability’ defined to include the range implied in the target. It is desirable to have only the upper limit for inflation for monetary policy measures to be put into operation. When there is a fall in prices below 2 per cent due to output/supply growth or cost-cutting measures, no attempt should be made to engage in an expansionary policy to provide an artificial boost to demand of the type attempted in the West or in Japan.

The Indian economy has become a high-cost one which is bad from both the domestic and the external points of view. The inflation target should not be fixed in such a way that prices get frozen at high levels.

The writer is a Mumbai-based economic consultant

COMMENT NOW