"Going beyond inflation targeting", 'The Hindu', August 18, 2015


Going beyond inflation targeting

By Pulapre Balakrishnan

In a commendable infusion of transparency into policy making, the Government of India has uploaded on the net a draft of the proposed Indian Financial Code (IFC). Within days of its being made available, it had received critical attention in the media. However, though the Code will apply to a wide range of matters financial, much of the response has concerned the monetary policy function. Within this, the focus has been on the relative power of the Reserve Bank of India (RBI) and the government in setting the policy interest rate. The draft, in effect, proposes that the government should have the greater say as, numerically, the government’s nominees are set to dominate the Monetary Policy Committee as envisaged in it.

Goal of monetary policy

This issue is easily resolved in principle. There can be no question that if the RBI is to be held accountable for monetary policy it should have full power to set the interest rate. An impression has been given that the proposal otherwise is itself  only a manifestation of the government’s attempt to cut the RBI leadership down to size. Naturally, this gives rise to some excitement among the public, but there is a much more fundamental issue at stake in the draft IFC, and this has received less than its due attention. It concerns the goal of monetary policy, and it is worrying that on this there is actually no disagreement between the government and the RBI! The draft IFC proposes that the goal of monetary policy shall be inflation targeting. “Inflation targeting” implies that the Central bank will give priority to the rise in prices. This had been the substantive recommendation of The Expert Committee to Revise and Strengthen the Monetary Policy Framework, constituted by the RBI in 2013.

To anyone who rightly worries about inflation, it is appropriate that the Central bank should be concerned with it. But to recommend that a Central bank focus on inflation does beg two questions. First, how effectively can the RBI control inflation? And, second, are there possibly adverse effects of attempting such control? The promise of inflation targeting is that inflation can be controlled by monetary policy and that there are no trade-offs to a policy of inflation targeting. This can hardly be assumed, and has been strongly contested by economists.

Going by recent history, there is reason for some scepticism about the RBI’s ability to control the inflation rate. From 2008 onwards, inflation had shifted gear upwards for five years. It would be difficult to square this with the suggestion that it reflects the Bank’s efforts to maintain growth, for growth has actually been lower in this period. While we have a complete explanation of the phenomenon of rising inflation and slowing growth, and it rests on the role of agricultural output fluctuations, it need not detain us here. The point of recounting this history is to suggest that it is far from clear that the RBI can fine-tune the inflation rate as is conveyed in the Draft IFC which states that the objective of monetary policy in India should be “price stability”, in the context to be understood as a stable inflation rate.

American parallel

However, let us set aside our scepticism and assume that a Central bank can control the inflation rate. Would inflation targeting be desirable now? We can best answer this by looking at recent experience in the United States. For a decade from the mid-1990s, the inflation rate there had been low and steady, eliciting the epithet “the Great Moderation”. But this phase had masked the brewing of a financial crisis in the form of an asset bubble, responsibility for which American commentators trace to the Federal Reserve that had, in view of the low inflation, maintained unusually low interest rates. A feeding frenzy had followed with credit fuelling house price increases. It is in the nature of inflation targetting that sectoral-price increases are ignored. When the bubble finally burst and house prices collapsed, the banks that had financed their purchase found themselves holding worthless assets. A spectacular intervention by the Federal Reserve, termed “unconventional monetary policy”, saved the day for the U.S. economy. This episode demonstrates two things. That financial crises are possible even with low inflation and that the Central bank can make a difference with respect to output. Though a U.S.-style crisis is unlikely in India, given so large a presence of the public sector, it does point to the need for the Central bank to be concerned with financial stability.

The policy response in the U.S. following the financial crisis was also mediated by  the  political consideration that an output collapse should be averted at all cost. Collective memory has a role to play in the political choices  nations make. Thus the Americans are perhaps haunted by the experience of the Great Depression when unemployment exceeded 25 per cent. This makes them unemployment averse. On the other hand, the Germans appear to be inflation averse, and you can hardly blame them for it. Inflation in the Weimar Republic had, at its peak in 1923, reached a vertiginous 32,000 per cent per month. There is a lesson in this for us, that India’s institutional architecture should reflect its own peculiarities and goals rather than be guided by pure theoretical constructs, allegedly based on some universal truth.


Inflation targeting

When the idea of inflation targeting had gained prominence in academia, the Federal Reserve had been lectured for not focussing on inflation. However, it is interesting to note that the U.S. has done far better than Europe in terms of employment post-crisis. Moreover, its record as far as inflationary expectations, and thus inflation, is concerned is no worse than that of countries with central banks that pursue inflation targeting. This is not surprising, for, as stated on its website, the Federal Reserve “is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices and moderate long-term interest rates”. By contrast, the Draft IFC declares that “The objective of monetary policy is to achieve price stability while striking a balance with the objective of the Central Government to achieve growth.” The point is that if the RBI is to pursue an inflation target set by the government it must  willy-nilly accept the growth that is got.

An argument for inflation targeting I have heard made at the highest level of India’s economic policy-making establishment is that in the long run there is no trade-off between inflation and unemployment. This is an assertion more ambiguous than it sounds. If it is a period of undefined duration that is meant by “long run” then we can never be assured that in this long run we are not simply in yet another short run. Alternatively, the long run could be seen as that state in which the economy has self-corrected and, ergo, there is no unemployment. Long ago, the economist, John Maynard Keynes, had restored perspective to this thought experiment. He had remarked “The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”

Note issue

So, what should the RBI be doing? Well, it should focus on output at least as much as it does on inflation, but this sits uncomfortably with the mandate of inflation targeting that is proposed in the draft IFC. Then it should continue its historic role of supervising the financial system, in which task it has done the Indian citizen proud by discharging itself without fear or favour. But there is a task on which it may have slipped a bit of late. Amid all the highfalutin talk of “anchoring expectations”, “forward guidance” and “the natural level of output”, it seems to have been forgotten that the RBI has the monopoly on the note issue, one granted with a view to facilitating economic exchange. Today, extreme hardship is caused by a shortage of small denomination currency notes in the bazaar. This raises transaction costs as agents struggle to make payment. And when the notes of the desired denomination are finally to be had they are so worn and soiled that it takes the joy out of truck and barter. Money may be a store of value, but it is also a medium of exchange. Surely the very thought of sparkling rupee notes  should be enough to bring together a proudly independent RBI and a government sworn to swachtha.

(Pulapre Balakrishnan teaches economics at Ashoka University.)