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Inflation targeting will stabilise the economy

By Sahil Kapoor
March 16, 2015 15:34 IST

Is the recent agreement between the Government of India and the Reserve Bank of India to make inflation targeting the central bank's prime focus the way to go? 

Rediff.com will publish a series of articles exploring the policy's pros and cons.

The first in the series: Why inflation targeting alone will not help India

In the second article in the series, Sahil Kapoor of Edelweiss Retail Capital Market Research says that setting up a monetary policy committee should have been the first step. And the central bank could have moved towards a formal inflation targeting mechanism after the processes and data sets are in place.

Image: In a country like India where pro-cyclical flows have a huge bearing on the currency and equity markets, a contained, less volatile inflation will definitely be credit positive. Photograph: Danish Ismail/Reuters

Inflation targeting is 25 years old. It was first adopted by New Zealand in 1990. Since then it has gained popularity around the world. Currently, there are around 25 central banks adopting this as their basic monetary policy framework. All major economies have an inflation target which has been established by their central bank.

For the UK and the US it is two per cent. The ECB aims just below this number. However, the nature of inflation targeting has evolved over the years.

Initially the primary tool that was used to achieve this target was the interest rates. After the 2008 crises, there has been a shift to unconventional monetary and fiscal policies like quantitative easing, asset purchases, helicopter money etc.

The New Monetary Policy Framework has been signed in India as well, by the central government and the central bank. As per the policy, the Reserve Bank will aim to bring inflation below six per cent by Jan 2016 and target a four per cent inflation rate with a band of +/- 2 per cent for subsequent years.

The monetary policy committee is yet to be set up.

As per the suggestion by the Financial Sector Legislative Reforms Commission, this committee will contain one executive member of the RBI board, three external members picked by the government and two external members picked by the government in consultation with the RBI governor.

The advantage of this set-up is that the RBI governor would have the right to veto a decision, but would have to issue a public statement explaining the same.

There are several advantages to the new monetary policy framework. The most important being, a formalised monetary policy helps in anchoring long-term inflation expectations.

Once the inflation expectations of households, businesses and workers are managed, they can ensure they charge, demand or pay in line with the inflation target. Usually, in extremely high or low inflationary environment, people’s expectations become a self-fulfilling prophecy. If individuals and businesses expect high inflation, they prepone their spending, adding to inflationary pressures.

Hence anchoring inflation becomes extremely important in such an economy. The new monetary policy framework ensures that the RBI governor and the finance minister are on the same page. Co-ordinated fiscal and monetary policies will not only help achieve the targets but also provide stability in the economy.

In the past few years, there have been contradicting targets and expectations of growth and inflation between the finance ministry and the RBI governor. This document ensures that there is some degree of consensus between the two. As per the new monetary policy, the RBI will release a document once every six months explaining the sources of inflation and the inflation forecast for the next six-18 months.

The benefit of this is there will be clear, transparent and continuous communication from the central bank.

Inflation targeting is not only the best mode of communication that can be utilised by a central bank, but also helps in establishing the accountability of the central banker.

For example, if the inflation target is not achieved for three consecutive quarters, the governor will have to explain the reason for the same, the corrective measures that will be taken and the new time horizon in which the target can be met.

Several empirical papers have found that, for emerging economies, the level and volatility of inflation have decreased significantly for countries that adopted the inflation targeting regime. Hence, in a country like India where pro-cyclical flows have a huge bearing on the currency and equity markets, a contained, less volatile inflation will definitely be a credit positive.

In fact, Moody's has already conveyed that the new ‘inflation targeting’ mechanism is a ‘credit positive’ move and it would make the RBI’s monetary policy tools much more effective.

From July-September 2013, after the Fed’s “taper tantrum”, we saw the rupee plunge and equity markets take a huge hit. Inflation went spiralling out of control and there were serious concerns regarding our balance of payments situation.

However, in September 2013, Raghuram Rajan was appointed as the RBI governor.

He has incorporated many changes in the monetary policy framework as suggested by the Urjit Patel Committee. The previous monetary policy documents have shown that the governor has been moving towards an inflation targeting mechanism. In several of his policy statements he mentioned the January 2016 target of six per cent and overall target of four per cent.

The formalising of this will further enhance the creditability and reputation of the central bank. The apprehensions usually surrounding inflation targeting is that other economic objectives may be compromised. However, India has adopted a flexible monetary policy.

As per the statement, 'The objective of the monetary policy framework is primarily to maintain price stability while keeping in mind the objective of growth.' This provides some amount of discretion to the central banker.

There are a few challenges that come to mind with this kind of a set-up. A scenario where there is cost-push inflation due to commodity price shocks may lead to interest rate hikes in spite of low growth.

The issue is that around 52 per cent of the Consumer Price Index basket is food and fuel, which is susceptible to supply side constraints, and hence making it tough for the RBI to control this aspect of inflation. Also the RBI remains constrained in its decision-making due to lack of accurate and frequent data on these economic data points.

In the US, the Fed tracks unemployment, retail sales and core inflation data. In India, the RBI is at a disadvantage. The industrial production data that is released has flaws and tends to be very volatile. There is no series to track employment regularly either. The lack of reliable data series on the same will make it tougher for the RBI to get a holistic view of the economy.

Although the RBI is viewed as an independent body, the central government can exert pressure on the central banker. The RBI governor is appointed by the central government and can be removed at the discretion of the central government. Hence, if there are divergent views between the two bodies, it is possible that the ability of the RBI to follow a pro-cyclical monetary policy will be challenged by political considerations.

Overall, although we are in favour of this step, we believe that the timing could have been better. Setting up a monetary policy committee should have been the first step. After the processes and data sets were in place, the central bank should have moved towards a formal inflation targeting mechanism.

The monetary policy framework will help reduce inflation volatility, anchor inflation expectations and improve the credibility of the central banker. But, it will definitely have to be complemented by government measures to ease supply side constraints as well.

Sahil Kapoor is AVP, Edelweiss Retail Capital Market Research.

Sahil Kapoor
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