Fine-tuning flexible inflation targeting

Possible extension and adjustment of flexible inflation targeting (FIT) due this month should be done keeping in mind aspects of it that are critically important in the Indian context.

The conceptual roots of FIT lie in developments in macroeconomic theory that led to a switch in central banking practice. The perfect foresight and market clearing view associated with the Real Business Cycle School implied that only unanticipated monetary shocks could affect real variables. Therefore, central banks aimed to keep markets ill-informed and surprise them with policy measures.

Perfection gave way to more realistic multiple equilibria associated with New Keynesian Economics. Under imperfect information, frictions and learning, markets can be stuck in outcomes where resources are not fully utilised. Central banks can help guide markets to better outcomes. Therefore clear central bank communication and guidance is important.

Therefore FIT has a clear long-term inflation target to guide and anchor inflation expectations. Multiple variables that affect inflation, growth and financial stability remain important, so in FIT the multiple indicator approach remains in the background. Only communication is focussed on inflation.

Apart from the policy rate, the tools include inflation forecasts that affect short-run inflation expectations. FIT is inherently forward-looking.

India is on a catch-up growth path where both labour and capital are plentiful and mobile long-run supply is quite elastic. Short-run bottlenecks, cost-push, as well as inflation expectations, however, push prices upwards. In such circumstances, aggregate demand affects output more and shifts in costs affect inflation.

Raising repo rates reduces output growth more than inflation but lowering supply-side costs, including inflation expectations, reduces inflation without hurting growth. The expectations channel of monetary transmission therefore works best to moderate inflation.

How has FIT worked in India?

In the initial years what was implemented was strict IT (inflation targeting) not FIT. There was a willingness to over-estimate inflation and keep interest rates above natural rates, in order to establish the long-run target. This delayed the convergence of inflation expectations despite the collapse of oil prices in 2014.

Since liquidity was also kept in deficit and there was no lender of last resort for NBFCs, as risk aversion peaked after the collapse of IL&FS, output sacrifice was unnecessarily large. But the post mid-2019 period has shown FIT is compatible with a weight on growth as well as on financial stability

The expectations channel is working. It has an inherent advantage in India. Since other sources of news are thin a lot of attention is paid to the RBI’s views and guidance. The estimated response coefficient to RBI communication is higher for India than it is for other countries. While expectations are still naïve there is evidence of anchoring.

A credible central bank and stable inflation lowers the country risk premium and cost of borrowing in an open economy. The long-term target is well established after five years.

Average inflation was around 4 per cent in the FIT period, core inflation from an estimated aggregate supply curve was 5 per cent in 2010s. So the 2 per cent band around 4 per cent is well worth continuing. But fine-tuning is required.

What needs to change?

One important issue is whether the target should be core or headline consumer inflation. The modified RBI Act 45-ZA says ‘consumer price index’ shall be the target. It should be possible to switch to core from headline as the target, without requiring a major change.

Core leaves out volatile commodities such as food and petrol from the CPI. When FIT was being introduced, food inflation was in double digits and had a major impact on inflation expectations, on households’ welfare and mind-space. Moreover research showed that causality ran from headline to core. So there were reasons for selecting headline as the target. But when conditions have changed, it would not be correct to continue with headline.

More recent research has shown that causality from food to headline holds only when food inflation is in double digits. Causality is now reversed. Moreover, headline has the disadvantage that more than 50 per cent of the basket comprises commodities that the RBI policy rate cannot affect.

The repo more directly affects the demand for industrial products and services, although expectations are also a part of industrial pricing.

Moreover, forecasts are important for anchoring expectations and they can be much more accurate for core. Lower volatility in guidance will reduce that in expectations and reduce distortions in real interest rates that arise if inflation is over-forecast.

In addition, research shows that core dominates household expectations in the long-run, although commodities may have more of a short-run impact.

RBI communication also affects expectations and its longer-run impact will rise if it is focussed on core inflation. Good communication also requires explaining clearly how the RBI affects inflation in India as well as the limitations in its ability to influence food and fuel inflation.

CPI as the target gives industry a raw deal since WPI inflation is normally much lower than CPI. This implies real product loan rates facing industry are much higher. There is normally less of a gap between WPI and core CPI. The latter is also closer to the GDP deflator, which is the most representative price level in the economy.

Given the focus on inflation, its measurement also needs to be improved. The basket and its weights should be updated frequently and the number and quality of goods and services included expanded.

Flexibility implies the target should be average and not point inflation. There is no point obsessing about the transient value of a not very reliable estimator.

The RBI Act 45-ZB states: ‘The MPC shall determine the Policy Rate required to achieve the IT.’ While the stance and forward guidance on repo rates can be fitted under ‘Policy Rate’, if some discussion of liquidity issues (liquidity adjustment facility, changes in reverse repo, FX intervention and OMOs) is also included in the remit of the MPC, it may result in greater transparency on the cost to the taxpayer of alternate interventions and help convergence to most effective procedures.

The writer is member of the RBI’s MPC. The views are personal

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