Containing Inflation Will Not Necessarily Contain Price Rise

Energy imports, uncertain monsoon and asset bubbles often shoot prices up. Moreover, supply side issues are beyond the pale of monetary policy. And filling the monetary policy committee with government nominees is a bad idea.

By now, many of us are aware of the new monetary policy framework that is set to be one of the crucial economic reform measures of the Raghuram Rajan era. This framework was introduced, albeit nebulously, in the Union Budget in February. It gives the Reserve Bank of India (RBI) the task of containing consumer price inflation to below 6 per cent until January 2016, and bring it down to 4 per cent by January 2018.

Since this pronouncement, many quarters have expressed their reservations with respect to the efficacy of inflation targeting – as it has hardly been successful in several countries that have adopted it – and the role that RBI will play in the new framework.

The monetary policy committee (MPC), for example, has the potential to diminish the central bank’s independence if a majority of its members are from the government sector or if Rajan does not get the power to veto the committee’s decisions. The key focus, therefore, should be on the prevention of conflicts of interest among members of the committee.

Former RBI Governor Bimal Jalan had suggested a five-member committee, of which three members would represent the central bank. But that still leaves the door open for conflicts of interest. Business Standard editor AK Bhattacharya in a recent media interview, therefore, suggested that the committee be fully headed by Rajan and that “it is better to have the RBI nominees and also have some knowledgeable experts on this, but government nominees I would be extremely uncomfortable with.” That is only right.

The agreement on the new monetary policy framework says:

“If the Reserve Bank fails to meet the target, it shall set out in a report to the Central Government (1) the reasons for its failure… (2) Remedial actions proposed by the Reserve Bank, and (3) an estimate of the time-period with which the target would be achieved…”

Why, after all, should there be government nominees in the committee when the policy lays most of the onus of containing inflation on the RBI? Then, there is also the issue of fiscal consolidation. When Rajan first reduced the interest rate early this year, he expressly stated that further cuts will depend on whether the government would stick to fiscal discipline (remember, greater government spending could potentially stoke inflation). So, at any given time, the RBI’s monetary policy is highly dependent on the actions of the government.

Even though we can reasonably trust that Finance Minister Arun Jaitley will be prudent in achieving his fiscal targets (which he expanded in the recent Budget), what if he fails? In that case, surely the RBI could tighten its reins on interest rates, but that would do nothing to address the basic issue of accountability on the fiscal front from the government.

The new regime of ‘inflation targeting’ thus seems to put disproportionate responsibility on the RBI. This, even though the central bank cannot possibly influence the prices of food and fuel through interest rates changes. As Rajan’s predecessor Subbarrao said in one of his speeches, “The drivers of inflation in India often emanate from the supply side, which are normally beyond the pale of monetary policy.”

For example, we are highly dependent on energy imports and uncertain monsoon, which often result in high volatility in food and fuel prices. In the consumer price index, food and beverages account for a staggering 45 per cent of the total weight, which means a supply shock to food items due to poor monsoon may raise prices and the RBI will be able to do nothing to contain them.

Even if the RBI were to focus on core inflation, which ignores food and fuel prices, it would hardly help the ordinary citizen who is still left poorer by high food prices. Joseph E Stiglitz, a Nobel laureate in economics and University Professor at Columbia University shares this view:

“Developing countries currently face higher rates of inflation not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries… Inflation in these countries is, for the most part, imported. Raising interest rates won’t have much impact on the international price of grains or fuel.”

Also, the theory that loose monetary policy (low interest rates) leads to goods inflation may not necessarily hold at all times. This was evident before and after the financial crisis of 2008 in the United States, when the monetary stimulus and loose credit norms did not lead to inflation, but instead to asset price bubbles. These bubbles may go unnoticed – till they burst, of course – to the central bank that is intent on targeting only the consumer price inflation.

In the words of Jeffrey Frankel, a professor at Harvard University’s Kennedy School of Government:

“That the boom-bust cycle could occur without inflation should not have come as a surprise. After all, the same thing happened when asset-price bubbles ended in crashes in the United States in 1929, Japan in 1990, and Thailand and Korea in 1997. And the hope of long-time US Federal Reserve Chairman Alan Greenspan that monetary easing could clean up the mess in the aftermath of such a crash proved wrong.”

Frankel goes on to assert that “the lack of response to asset bubbles was probably inflation targeting’s biggest failing.”

A relentless focus on inflation targeting, which is the central issue of the new proposed monetary framework, may divert the central bank’s attention from other factors that are equally disastrous (such asset price bubbles and supply shocks) for the economy. At the very least, more clarity from Rajan in terms of how he is prepared to tackle these issues, which have historically challenged many countries pursuing similar monetary framework, would be welcome.