The flexible inflation targeting framework adopted by RBI in 2016 is considered a significant economic reform in India post 2000. Under this framework, maintaining a 4 per cent CPI headline inflation gets the highest priority in the hierarchy of monetary policy objectives. This rule based policy making renders monetary policy transparent and predictable.
However, of late, adoption of this framework is being criticised on many accounts. Many experts believe that such single minded monetary policy making is not suitable for an emerging country like India. They indirectly hold this framework responsible for accelerating the slow-down of the Indian economy.
Further, its efficacy in maintaining a stable inflation in India has also been questioned. This is particularly imperative when the CPI inflation has gone up and has remained over 6 per cent for several months, and GDP growth rate had crashed much below its potential long before the Covid-19 pandemic hit the Indian economy. Its initial success of maintaining inflation around the target during 2016-2019 was attributed to ‘good luck’ over ‘good policy’.
The so called good luck factor was primarily driven by low crude oil prices and favourable supply responses during this period. During the Covid-19 pandemic, when the aggregate demand has plummeted, CPI inflation has gone up further, apparently due to adverse supply shocks. These features naturally make one think that the current framework is not tested long enough to take a final call if inflation targeting is suitable for India.
While there are merits in such arguments, they are not necessarily based on scientific empirical evidence. Indeed, efficacy of adopting inflation targeting in the emerging economies is an under-researched area. In the Indian context, early evidence underscores the importance of the new monetary policy framework (See Pankaj Kumar and others - “What is Responsible for India’s Sharp Disinflation?” in Monetary Policy in India: A Modern Macroeconomic Perspective, 425-452, Editors - Chetan Ghate and Kenneth M. Kletzer, Springer, 2018).
Their study, based on advanced time series techniques, shows that while supply side factors are important, the new monetary policy framework contributed significantly in maintaining a stable and low inflation since 2016.
Inflation targeting, a challenge
That targeting inflation in India would be challenging was known from the beginning. What was more ambitious and presumably a bold step was the targeting of CPI (combined) headline inflation. In CPI (combined), the food and beverages component has a weight of 45.86 per cent.
No other country in the world has adopted an inflation targeting framework with a price index that has such large food weight. Indonesia, a relatively comparable inflation targeting economy, has food and beverages weight of just over 25 per cent in its CPI. For inflation-targeting developed nations, food weights in CPI are far lower.
As the economy transits from lower to higher income, the relative importance of food as captured by the share of its expenditure in the overall consumption basket falls. India is not an exception and its share of food in consumption expenditure has also been declining. However, the decline has been gradual and painstakingly slow.
For example, during a period of almost two and half decades starting from 1987-88, the share of food in consumption expenditure for rural India declined slowly from 64.0 per cent to 48.6 per cent (Chart 1). For urban India too, this decline has been sluggish, almost keeping the same pace of change with rural India.
In this context, there are two critical reasons why inflation targeting with current CPI is extraordinarily challenging in India. First, the higher the weight of food in CPI, the lower is the monetary policy control RBI can directly exercise to influence the actual inflation outcome. So we have a price index on about half of which RBI has little policy control.
Second is the inherent high volatility of food inflation in India. Because of higher food contribution, headline CPI inflation volatility gets exacerbated manifold. Higher the volatility, greater is the difficulty in predicting it and hence suboptimal policy choices. Therefore, the criticism that RBI is unable to predict inflation is somewhat unfair. It is more due to choosing an inflation metric that is notoriously difficult to predict.
It cannot be the case that the RBI did not apprehend these challenges while adopting the inflation targeting framework. It was envisaged that the food weight in CPI will decline with progressive revision of the price index and hence monetary policy will gain higher control over inflation management.
This was a possible reality to some extent as the consumer expenditure survey results of 2017-18 were due for release in November 2019 and a revision of CPI was anticipated soon. However, allegedly due to some disconcerting findings on the monthly average consumption expenditure in relation with the earlier survey findings, the consumer expenditure survey 2017-18 was junked.
The official version reads, “in view of the data quality issues, the ministry has decided not to release the Consumer Expenditure Survey results of 2017-2018,” and it “is separately examining the feasibility of conducting the next Consumer Expenditure Survey in 2020-2021 and 2021-22 after incorporating all data quality refinements in the survey process.”
Post Covid-19, nobody knows if the years 2020-21 or 2021-22 would be normal years to undertake the next Consumer Expenditure Survey. That means we may not get another revision of CPI, say until 2025. In effect RBI will continue to struggle to manage inflation for using an imperfect nominal anchor. It was not just a blow to the credibility of the one of the best statistical systems in the world, it has made monetary policy making shaky and far more challenging under the new framework. Had there been another revision in 2019, we would have seen a somewhat balanced weighting schemes of consumption items.
This is borne by the fact that the food and beverage weight in CPI-IW (which has been recently revised with 2016 as the base), has declined from 46.2 per cent to 39.2 per cent. If one of the key objectives of monetary policy is to bring welfare to the people by means of achieving a low and stable inflation, targeting CPI inflation is a natural alternative.
Given the structure of CPI, the new framework can effectively bring transparency and predictability in monetary policy making, if the burden is squarely shouldered by both the RBI and the government. Therefore, it is not just the RBI, the government is also accountable for timely supply responses and making monetary policy effective.
The writer is Professor of Economics at IIM-Ahmedabad