The re-evaluation of inflation targeting

Pulapre Balakrishnan and M. Parameswaran


As the term of the original agreement between Government of India and Reserve Bank of India (RBI) on inflation targeting (IT) ends on March 31, evaluations of this aspect of m0onetary policy have begun to emerge into the public domain. Two points have been made: first, that the inflation rate has remained within the prescribed band of 2-6 percent since 2016, when IT was introduced, and, that the RBI has succeeded in anchoring inflationary expectations. In fact, the lower inflation rate is seen as the outcome of the latter. Our long-term research on inflation in India suggests that the evidence is not conclusive on the efficacy claimed for IT.

            Though macroeconomic policy may not be to everybody’s interest, a rudimentary understanding of what is meant by inflation targeting is advisable for each, especially as it is adopted in their name. Inflation targeting is only one of a set of imagined inflation control policies. Globally, inflation control became de rigueur after the high inflation that followed the oil shock in the early seventies. Indeed, well before IT was advanced, Milton Friedman had brought inflation control centrestage through his relentless highlighting of the ever-lurking danger of inflation. In India, on the other hand, policy makers had engaged with inflation since the nineteen fifties when plans to industrialise met the challenge of inflation. Thus, scepticism about IT as a strategy of inflation control does not imply the stance that inflation control is not a legitimate objective of economic policy. While the monetarist Friedman had prescribed money-supply targeting as the means to control inflation, IT prescribes the use of the interest rate to target inflation. So, really, what is new about inflation targeting is only the instrument chosen, not the goal itself. There is, however, the vague suggestion that IT is likely to be more effective than the monetarist approach, as the instrument – the policy interest rate – is directly under the control of the central bank. However, what has mostly remain hidden in the public discourse is the economic model that underlies inflation targeting. This model revolves around the proposition that inflation reflects “overheating” or economic activity at a level greater than the ‘natural’ level of output, having been taken there by central banks that have kept interest rates too low; specifically, at a level lower than the ‘natural’ rate of interest. From this follows the recommendation that the cure to inflation is to raise the rate of interest set by the central bank, the so-called policy rate, which in India is termed the ‘repo’. A feature of this theory of inflation is that its central construct, the natural level of output, is unobservable. This makes it next to impossible to verify it. It also renders it self-referential. It is as if the exponent starts out stating that the inflation rate is rising as the output is higher than its natural level. When asked how it has been concluded that output is actually higher, the response is “for inflation is rising”. Understanding phenomena on the basis of faith is not scientific. Despite this logical vulnerability, IT is a reality in that it is Government of India’s stated policy of inflation control.

            Our work demonstrates that the model underlies IT is not statistically validated for Indian data. As the details are unlikely to be of interest to the general public we do not dwell on this finding except to state that it of the essence from the scientific point of view. Instead, we shall see if the recent history of inflation is supportive of the claim that inflation targeting has been successful on grounds that the inflation rate has remained within the band agreed to between the government and the RBI. As it has been further claimed that this has been achieved by “anchoring inflation expectations” we shall scrutinize this too.

            Inflation in India entered the prescribed band of 2-6 percent two years before IT was adopted in 2016-17. In fact, inflation had fallen steadily since 2011-12, halving by 2015-16. This by itself suggests that there is a mechanism driving inflation other than what is imagined in IT. The view is further strengthened when we find that the decline in inflation over the five years concerned has been led by the relative price of food. While falling food-price inflation per se does not rule out the possibility that expectations of inflation may have fallen in this period, it would be difficult to explain why expectations would have fallen so sharply even in the absence of IT, considered essential for anchoring expectations. Recall that its adoption in 2016 came after inflation had entered the prescribed band. RBI data on household expectations show them remaining well above 6 percent for twelve years upto 2020. Finally, it is the flaring up of both inflation and inflation expectations after March 2020 when the lockdown was announced that makes it difficult to believe the thesis of a “overheating” economy. Why did expectations soar if they had been anchored through IT? On the other hand, we can explain the flaring up of inflation by resort to rising food prices, as supply chains were disrupted due to the lockdown.

            In conclusion, for the sake of argument let us for a moment assume that over the past five years inflation in India has been controlled via IT. We may then ask what the benefits of this have been. We can think of five variables of interest in the context, namely growth, private investment, exports, non-performing assets (NPAs) of commercial banks and employment. The economy’s trend rate of growth actually began to decline after 2010-11, so inflation targeting could not have caused it but it is of interest that sharply falling inflation could do nothing to revive growth, belying the proposition that low inflation is conducive to growth. What about investment? Here there is reason to believe that higher interest rates, the toolkit of IT, may have been harmful. The swing in the real interest rate of over 5 percentage points in 2013-14 was powered further in 2016, when IT was adopted, could have contributed to a declining private investment rate. It is interesting that policy entrepreneurs hold out the benefits of low inflation as being most for private investment. We need say nothing about more about exports and employment except that they had fared poorly since IT became official. Finally, NPAs. It has long been recognized that a central bank focusing on inflation could lose control of financial stability. NPAs have grown since 2016, and the cases of IL&FS, PMC Bank, PNB and YES Bank suggest that poor management and malfeasance in the financial sector could escape scrutiny when the central bank hunkers down to inflation targeting alone.

            We end with two points. Inflation control will always be relevant but there is no conclusive evidence that IT has worked in India. Secondly, the presumed benefits of low inflation are yet to surface. So, we should guard against the possibility that IT delivers the worst of all worlds, i.e., raising interest rates, with all negative consequences, without lowering inflation. Lastly, assuming that the decline in inflation in India is due to IT would stand in the way of our going to the source, which is rising food prices.