"The Case Against Inflation Targeting", 'The Hindu Business Line', March 30, 2014

The case against inflation targeting

Pulapre Balakrishnan


The recent report of a committee constituted by the Reserve Bank of India has proposed a radical rethinking of the goal of monetary policy and how it ought  be conducted. Specifically, the Committee has recommended that the RBI should target inflation, and that the means of inflation control should be the interest rate that it directly sets, the so-called ‘repo’. If this recommendation were to be accepted it would imply a shifting away from the RBI’s erstwhile approach of being guided by multiple indicators, weighing equally among its objectives growth and inflation. But above all it begs the question whether the central bank can control inflation in India. Two questions come to mind as we evaluate the proposal. The first has to do with the record of inflation targeting in the countries where it has been adopted as the central task of monetary policy. The second has to do with the relevance of an inflation targeting central bank for India.

            To evaluate the argument for inflation targeting one needs to be aware of the global history of monetary policy. It is not as if the case for inflation control is being made for the first time. Only, inflation control had been attempted via control of the money supply. Central banks had targeted the money supply, ostensibly as the means to control inflation. Milton Friedman was the guru of this strategy and Margaret Thatcher his most zealous shishya. But Thatcher was soon to discover that controlling the money supply was not akin to turning on and off the water tap. To control the growth of the money supply she had to resort to fiscal policy, in itself an acknowledgement of defeat for a ‘monetarism’. Of course, this had had for her the attractive side-effect that it lessened the size of government. Inflation did come down in the UK, but it was pointed out that this was the result of declining global commodity prices, and not due to the unemployment that was engineered as a result of her policies. The American central banker Paul Volcker did manage to control inflation in the US but by ushering in the biggest recession since the 1930s and tipping the Latin American economies in hock to US banks into a debt crisis due to the high-interest-rate policy. We see a certain commonality here. Monetary, or even fiscal solutions, to inflation can result in output loss. After Thatcher and Volcker neither the UK nor the US have experienced high inflation, but this is not so easily ascribed to successful inflation targeting by their central banks. It has to do with the decline in union power and the lessened dependence of both these economies to imported oil. While the US pursued strategic substitution serendipity delivered oil in its backyard to the UK. And now globalization has further lowered the bargaining power of labour vis-à-vis capital as the latter is mobile while the former is not.

            The aspiration for an independent inflation-targeting central bank for India is part of the project of taking India’s institutional architechture as close to the Anglo-Saxon one as possible. After the global financial crisis this no longer has credibility. That is has cachet among India’s ruling elites is just pathetic. The theoretical case for inflation targeting is built by asserting that but for unanticipated inflation the labour market, and thus the economy, would achieve an optimum that cannot be improved upon by policy. So unanticipated inflation causes a costly distortion to be avoided. As it is held that willy nilly the central bank is ultimately the cause of inflation, in this view of the world it must be held to account via an explicit agreement with government that it will target it. As has already been stated, this begs the question of how the central bank is to control inflation. Those who argue for inflation targeting assert that today’s inflation is determined by the expectation of inflation tomorrow. Asserting further that the central bank controls inflation, they propose that all that is necessary is for the central bank to announce a lower inflation target and a rational public will scale down expectation of inflation and thus lower its actual level. This nice story sits uncomfortably with the history that even a bank with so formidable a reputation for expertise as the Bank of England has had repeatedly to write to Her Majesty’s Government explaining why it has slipped on the inflation targets agreed upon.

            We now come to India. Despite its shrinking share the agricultural sector plays an important role in generating and sustaining inflation here. This is due to its weak response to a supply-demand imbalance.  Natural factors, poor publicly-provided infrastructure, and low human-resource development all conspire to bring this about. But we also know that some part of the recent food price inflation has little to do with supply. It has to do with the relentless hiking of producer prices even as public stocks have piled up. The government has continuously raised the farm price for cereals irrespective of its impact on inflation. In the face of both types of food inflation alluded to above a central bank has no instruments. The RBI’s justification that it “anchors inflationary expectations” by raising the interest rate is no more than whistling in the dark. As a general rule, attempted monetary solutions to supply-side inflation result in the inflation rate being brought down via slowing output growth. We have seen this in the UK and the US in the 1980s, and we see it in India over the past 3 years or so. Note that the news that inflation is slowing now must be read along with the information that manufacturing is struggling to grow. Inflation control in India must start with fixing the agricultural price rise. Increasing productivity would be the sine qua non here.

Does a secondary role, if at all, with respect to inflation control render the central bank irrelevant in India? Far from it. A central bank is the main regulator of the financial system. The Reserve Bank of India has a pretty good record here. It also has a reputation for being at arm’s length with private banks and finance companies. This is in sharp contrast with the Greenspan years in the US when Wall Street is believed to have been treated with kid gloves. In India the RBI has an enviable reputation for probity and is currently headed by an economist of the highest credentials in a global comparison. However, there is one area in which the Bank fails quite miserably, this is in regulating the note issue on which it has the monopoly. Across India one is confronted with shabby currency notes and a endemic shortage of smaller denomination notes and of coinage. Attempt to take a taxi-ride or buy a cup of tea and you find yourself struggling to complete the transaction. There is creeping inflation when prices have to be rounded-off upwards to ensure that exchange takes place. There is also inflation due to output loss as the two parties scramble about to overcome the shortage of the medium of exchange. This wasteful activity delays the creation of wealth in an economy with unemployed resources. The RBI has its task cut out.