The Narendra Modi-government’s decision to stick to the central target of four per cent for consumer price index (CPI) inflation confirms that the Centre does not have immediate plans to deviate from the inflation-targeting monetary policy initiated by the Reserve Bank of India (RBI) under governor Raghuram Rajan.
On Friday, junior Finance Minister Arjun Ram Meghwal tabled a notification in Rajya Sabha that confirmed the inflation target at four percent (plus or minus two percent), in line with the goal the government originally agreed with the RBI. The RBI will aim to keep consumer price inflation at four percent through 2021, while allowing the rate to fluctuate in a 2 percent to 6 percent band, Meghwal’s statement said.
By doing this, the government has sent two important, clear messages: First, it doesn’t want to mess up the RBI’s way of dealing with inflation seeking sharp rate cuts. Second, it is a clear message that the government doesn’t agree with Rajan’s critics such as BJP MP Subramanian Swamy, who argued that the central bank is deliberately keeping rates too high and thus killing economic growth. Besides Swamy, there were a few others in the Modi government who questioned Rajan’s interest rate policies and inflation-targeting.
Rajan is set to leave the RBI in the first week of September.
Under the existing agreement between the central bank and the government, the RBI will focus on a CPI target of four percent with a plus or minus two percent band for financial year 2016-17 and all subsequent years. Also, RBI has been given a 2-6 percent band, beyond which if inflation moves, the central bank has to explain to the government in writing why it failed to keep the figure within the limit.
In other words, it is akin to the RBI’s credibility and its ability to manage inflation being questioned in public. That's an ignominy the central bank suffered when the Chief Economic Advisor’s mid-year economic analysis for 2014-15 made a scathing criticism on the RBI saying monetary policy lost its credibility between 2007 and 2013 on account of high inflation and hence negative real interest rates. “India lost monetary policy credibility, reflected in the fact that real policy interest rates were consistently negative at a time when inflation was persistently in the double digit territory," said the report.
Y V Reddy was the governor between September 2003 and September 2008. He was succeeded by D Subbarao, whose term lasted until September 2013. Current governor Raghuram Rajan took over on 4 September 2013. From early 2014, the central bank began to regain control on the inflation battle. From double-digit levels in late 2013, the retail inflation was brought down consistently to below six percent levels since September 2014, i.e. one year after Rajan took over. Since then the highest point CPI inflation has reached is the last reading (June) at 5.77 percent, dangerously closer to the six percent upper target. This should ring alarm bells in the central bank and especially to the new RBI governor who will succeed Rajan.
In this context, the government’s confirmation that it is on the side of the central bank on the fight against inflation will give lot of comfort to Rajan’s successor, who has a massive task ahead. This is particularly crucial given that the new joint monetary policy structure is being worked out. Typically, Governments tend to take a short-term view and prioritize growth more than inflation.
Without sustainable low-inflation, growth wouldn’t mean much to the India’s poor. This is something outgoing RBI governor, Rajan has highlighted in the past. “When people say inflation is low, you can now turn to stimulating growth, they really do not understand that these are two sides of the same coin. The RBI always sets the policy rate as low as it can, consistent with meeting its inflation objective,” Rajan said recently.
Higher prices of essential food and vegetable items are already hurting India’s poor. Here, the problem is more on account of supply shortage and not high interest rates. The government will have to work out ways to increase production, prevent hoarding and think about use of innovative technology to enhance the efficiency of cultivation given that land area is not rising.
For his inflation stance, Rajan had found supporters like 2013 economics Nobel Prize winner, Lars Peter Hansen who said the RBI should continue with its focus on inflation. “The central bank should, as it has been doing so far, continue to focus on inflation. I think much too often people expect the central bank to do too much,” said Hansen.
In a recent article, Firstpost had strongly argued that the government shouldn’t dilute/revise the inflation target that is currently pursued by the central bank (5 percent by early 2017 and 4 per cent by 2018), citing that such a revision will be a huge negative for the economy and will reverse the gains of a hard-fought inflation battle.
The Modi government’s decision to stick to the central bank’s target is a right step.