“First, a rethinking of the framework for analysis of inflation away from paradigms largely borrowed from developed countries and towards one that is appropriate for the Indian context is needed” — T N Srinivasan
Reserve Bank of India (RBI) Governor Raghuram Rajan’s rockstar status and the acrimony surrounding his decision to step down have ensured that boring debates about central bank independence, inflation targeting, and policy transparency have become ‘page three’ material. Given Rajan’s impeccable professional credentials and his record as an independent thinker, his impending departure has stoked concerns that politics is interfering with good economics. Under the Monetary Policy Framework Agreement, the government and the RBI agreed to put in place an explicit inflation target—in economic jargon, the government has now adopted inflation targeting (IT) as the primary objective of monetary policy. Having set an explicit target, the government should leave it to the RBI to decide how best to achieve the target. Of course, the RBI should be accountable, but quibbling about interest rate policy is tantamount to micromanaging—neither a good management principle nor good politics.
Lost in the din about short-term policy moves is the dangers posed by India’s embrace of a seriously flawed monetary policy framework that is especially unsuited to the country. Until the global financial crisis of 2008-2009, IT was considered the ideal benchmark for monetary policy. However, the crisis and its aftermath have forced many economists to question IT. There is greater recognition that IT often tends to foster long-term imbalances in debt, leverage, asset prices and exchange rates, making the economy more financially fragile. Fragility leads to financial crises and perversely undermines inflation targeting.
There are a number of reasons why IT is especially unsuited to India. Policy that aims to balance economic growth, financial stability, exchange rate stability, and inflation—not very different from what the RBI practiced—is more likely to deliver moderate inflation over the long haul than targeting inflation directly.
Analysing the recent inflationary episode
“In India’s six-decade economic history, the list of policy successes is short. But the one prominent item on this list must be India’s management of inflation and the exchange rate, a considerable achievement given that moderate inflation was achieved in the face of three decades of fiscal laxity” — Arvind Subramanian, present chief economic adviser to the government of India, in 2008.
Since 2008, inflation in India
has been not quite “moderate”, but the slippage has to be judged in light of
the extenuating circumstances.
First, global commodity prices had a parabolic rise up to 2011 (and remained elevated until 2014). Given that India is a net importer of commodities, especially petroleum, the rise in domestic inflation actually appears moderate when compared with previous episodes of zooming commodity prices. It is hard to see how monetary policy could have controlled inflation without slowing the economy sharply and it is hardly clear that such a course would have succeeded. Weakening growth may well have triggered capital outflows, leading to an even weaker rupee and causing stagflation. Note that Brazil has experienced something along these lines in the past three years.
Second, India was hit with a drought just when global food prices were skyrocketing in 2010-11. (As an aside, recall that rising food prices was one of the proximate causes of the Arab Spring.) Once again, the culprit is poor public administration rather than an inadequate monetary policy framework. Interestingly, eminent economist T N Srinivasan noted in a lecture in 2011 that then finance minister R Venkatraman presenting his 1980-81 budget called for coordinated supply and demand measures to find a durable solution to inflation. Unfortunately, not much has changed in 30 years!
Third, the need to take insurance against the global economic collapse in 2008 meant that the RBI had to drop rates amidst still-high consumer price inflation. One can fault the RBI for waiting too long to raise interest rates in 2010, but it is hard to fault the RBI for dropping rates amid the worst global economic collapse since the 1930s. The US Federal Reserve too ignored the fact that inflation was persistently running high and cut rates sharply in 2008. Perhaps an inflation-targeting central bank would have raised rates in 2008. Indeed, the European Central Bank (ECB) raised rates in July 2008 on the eve of the global collapse and did so again in 2011 on the eve of the European debt crisis. I am not sure how many economists will claim that the RBI should have emulated the ECB!
Fourth, the European debt crisis of 2011-2012 and the accompanying global financial turmoil sharply weakened the rupee, further fanning the embers of inflation even as the RBI kept rates elevated. Moreover, the ensuing European recession brought India’s export growth to a halt, causing the current account balance to worsen and exerting downward pressure on the rupee.
To paraphrase Robert Clive, the RBI should be astonished that inflation was so moderate during the past few years.
Flippancy aside, the roots of the
recent high inflation lay in the pre-2008 period. Gross bank credit grew at
well over 25 percent, annual rate, from 2005 through 2008, consistently
recording a 30 percent plus growth from 2005-2007. Nominal GDP growth averaged
about 16 percent during that time. In other words, credit was growing much
faster than income. Despite soaring credit, one reason why inflation remained
subdued was because we were lucky to have a string of normal monsoons (see
In addition, the rupee appreciated, blunting the impact of rising petroleum and other commodity prices. If the RBI had clamped down on credit growth, economic growth would have been slower but we would not have bottled up inflationary pressures that bedeviled India in the past few years. It is easy to conduct policy with the benefit of hindsight, but the lesson here is that a mere focus on inflation is not enough—many other indicators need to be monitored. Inflation, like fever, is a symptom of underlying problems and the fever is often a lagging indicator of the problem.
The case against inflation targeting
India does not need the institutional fix of IT to keep inflation low because there is a strong societal consensus in favour of low inflation. With some exaggeration, India might even claim that it already has the mother of all inflation targeting regimes – Arvind Subramanian, in 2008
Before considering the
suitability of IT for India, let us briefly look at the origins of IT and its
record. The inflation of the 1970s caused an upheaval in macroeconomics and in
central banking. A triumphant Milton Friedman, who is said to have correctly
predicted the surge in inflation (never mind that he also predicted surging
inflation in the 1980s, which didn’t exactly pan out), advocated following a
strict rule of growing the money supply at a steady rate as the recipe for
stable inflation. He was backed up by seminal papers of the era that argued for
rules and against discretion in policy.
However, central banks’ attempts to target money supply growth failed in the 1980s. Yet, the quest for a rule-based policy framework persisted and gave rise to IT. The Fed and the Bank of Japan were among the last developed countries to adopt IT in 2012 and 2013 respectively. Interestingly, both of them adopted IT not because inflation was high but because they were worried about low inflation and entrenched deflation, respectively.
Let us now look at why IT is especially unsuited to India. I will use Governor Rajan’s recent speech at Tata Institute of Fundamental Research as a foil.
Inflation and growth
Very few people would argue that extremely high inflation is good for growth. So, the key question is whether there is a threshold above which inflation hurts growth. Economics literature is inconclusive. A cross country study by Bruno and Easterly found that inflation above 40 percent hurts growth. Recent studies have arrived at much lower thresholds. In particular, India-specific studies find very low thresholds—in the five-six percent range. I find the India-specific studies very unpersuasive (not that I find the other studies especially persuasive). The fact that most periods of high inflation in India are related to monsoon shortfalls or global commodity prices (chart below) should tell you that the problem lies elsewhere and inflation is a symptom not the cause. It is worth noting that South Korea, during its boom in the 1960s and 70s, generally experienced double-digit inflation.
In his speech, Governor Rajan, arguing against a higher inflation target, noted that even moderately higher inflation would mean greater distortion of relative prices and would therefore be damaging to the economy. Implicit in the claim is an assumption that left to their devices free markets will generate relative price signals that are optimal—a very questionable assumption. From a theoretical point of view, whether inflation is costly in terms of distorting relative prices is a complex question for which there are no straightforward answers. Recent empirical work with US data suggests that the link between high inflation and high relative price changes is non-existent.
Bottom line: The basis for a low, as opposed to moderate, inflation target rests on shaky foundations.
Low interest rates do not spur business capital spending
In his speech, the governor also argued that IT will reduce interest rates in the long term and thereby induce higher capital spending. There is very little evidence that interest rates have a significant influence on capital spending. I am not aware of any study related to India, but research has shown that internal hurdle rates at firms in the US have remained remarkably stable at around 15 percent for decades. Given high hurdle rates, targeting low inflation means that nominal growth will be low and fewer projects will overcome the hurdle rate. Thus, low inflation may actually hurt investment, and a casual perusal of data suggests that this might well be the case.
Inflation and poverty
The governor also made the common argument that inflation hurts the poor disproportionately. In India, there is a huge population of urban poor and rural landless workers who are heavily affected by food prices because food constitutes a bulk of their spending. Since most inflationary episodes in India have involved rising food prices, it is not surprising that inflation hurts the poor disproportionately. The chart below shows the poverty rate in India. Unfortunately, many data points on poverty are missing and have been interpolated—the entire period from mid 1970s to mid 1980s has a large number of missing points. Nonetheless, we can see that the inflation in the early 1960s caused a jump in poverty. Similarly, the inflation of the early 1990s caused the poverty to rise somewhat and the improvement to stall for a few years. So, inflation being bad for the poor is evident. Interestingly, note that the recent episode of accelerating inflation does not appear to have adversely impacted the progress in poverty reduction.
If inflation hurts the poor, weak growth hurts them much more (see the second chart below). In the short term, fighting inflation hurts growth and is likely to hurt the poor. Ultimately, if we want to mitigate the adverse impact of inflation on the poor, policy needs to address food supply and distribution instead of focusing on inflation fighting.
Inflation targeting not suited for developing countries
It is well known that India, like many other developing countries, is subject to large shocks to supply (such as drought) and terms-of-trade (that is, our export prices rise less than our import prices). Under such circumstances, recent research shows that inflation targeting is not the best policy. Under IT, the central bank is supposed to let the exchange rate float and not intervene. Left to market forces, developing countries will experience large exchange rate moves. Given that capital flows into emerging markets when times are good and flows out when times are bad, exchange rate moves will tend to amplify domestic financial excesses in good times and exacerbate financial instability during economic downturns.
Until the adoption of IT, RBI followed multiple objectives. It appears that their policy ended up roughly stabilising the real exchange rate of the rupee (see chart below). Note the contrast to Brazil and Indonesia, both of whom target inflation. Brazil and Indonesia have had lower inflation variability than India. The question is whether lower exchange rate variability or lower inflation variability is better for economic performance. If you look at GDP growth or stock markets, India has vastly outperformed Brazil and handily outperformed Indonesia, Turkey, South Africa, among other IT deploying nations over the past 10 years (see chart below).
“But the current crisis has demonstrated vividly that price stability is not sufficient for economic stability more generally. Low and stable inflation did not prevent a banking crisis. Did the single-minded pursuit of consumer price stability allow a disaster to unfold? Would it have been better to accept sustained periods of below or above target inflation in order to prevent the build up of imbalances in the financial system? Is there, in other words, sometimes a trade-off between price stability and financial stability?” — Mervyn King, former Bank of England governor, October 2012.
There has been greater recognition that IT often leads central bankers to ignore buildup in financial imbalances. So, even the ardent supporters have argued for a flexible IT that includes consideration of financial imbalances. Piti Disyatat of the Bank of Thailand has argued that even a flexible IT may not be enough, there needs to be an explicit targeting of financial imbalances as well. Indeed, the RBI in its multiple objectives always kept an eye on financial imbalances.
In adopting inflation targeting, India may have discarded a robust and serviceable framework for a dubious one.
- What is inflation targeting?
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