Is inflation targeting really the way out for RBI?

The Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework of the Reserve Bank of India (RBI) was recently released. The Committee has recommended that the RBI follow a policy of inflation targeting. This strategy essentially involves a central bank estimating and projecting an inflation target, which may or may not be made public, and then using interest rates and other monetary tools to steer the economy toward the projected inflation target.

The Committee has recommended that the RBI sets an inflation target of 4%, with a band of +/- 2 percent around it . The Committee has further recommended that the “transition path to the target zone should be graduated to bringing down in?ation from the current level of 10 percent to 8 percent over a period not exceeding the next 12 months and 6 percent over a period not exceeding the next 24 month period before formally adopting the recommended target of 4 percent in?ation with a band of +/- 2 percent.”

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These recommendations are in line with the thinking of the RBI governor, Raghuram Rajan. Rajan believes that the RBI should be concentrating on controlling inflation, instead of trying to do too many things at the same time.

As Rajan wrote in a 2008 article (along with Eswar Prasad) “The central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”

[caption id=“attachment_1160397” align=“alignleft” width=“380”]  RBI Governor, Raghuram Rajan. AP[/caption]

And given this the RBI ends up being neither here nor there. As Rajan and Prasad put it “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.”

Hence, Rajan felt that the RBI should ‘just’ focus on controlling inflation. As he wrote in the 2008 Report of the Committee on Financial Sector Reforms"The RBI can best serve the cause of growth by focusing on controlling inflation."

So far so good. The trouble is that inflation targeting has come in for a lot of criticism since the advent of the current financial crisis. As Taumir Baig and Kaushik Das of Deutsche Bank Research write in note titled RBI’s path towards (soft) inflation targeting and dated January 22, 2014, “The period since the 2008 global financial crisis has not been kind to the theory and practice of inflation targeting. After two decades of enthusiastic embrace by many central banks, both from advanced (e.g. Australia and UK) and emerging market (Brazil, Thailand) economies, the wisdom and efficacy of inflation targeting have came under intense scrutiny.”

And why is that the case? Inflation targeting might have been one of the major reasons behind the current financial crisis. Stephen D. King, group chief economist of HSBC makes this point in his book When the Money Runs Out. As he writes, “the pursuit of inflation-targetting … may have contributed to the West’s financial downfall.” He gives the example of the United Kingdom to make his point: “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation. In other words, credit conditions domestically became excessively loose… The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.”

Essentially, since consumer price inflation was very low, the Bank of England, the British central bank, ended up keeping interest rates low for too long. This led to a huge real estate bubble in the United Kingdom. A similar dynamic played out in the United States as well, where inflation between 2001 and 2004 varied between 1.6 and 2.7 percent.

With interest rates being low, banks were falling over one another to lend money to anyone who was willing to borrow. And this gradually led to a fall in lending standards. People who did not have the ability to repay were also being given loans.

As King writes, “With the UK financial system now awash with liquidity, lending increased rapidly both within the financial system and to other parts of the economy that, frankly, did not need any refreshing. In particular, the property sector boomed thanks to an abundance of credit and a gradual reduction in lending standards.”

This inflation only focus turned out to be disastrous as other economic factors were ignored. As Felix Martin writes in Money-The Unauthorised Biography “The single minded pursuit of low and stable inflation not only drew attention away from the other monetary and financial factors that were to bring the global economy to its knees in 2008-it exacerbated them… Disconcerting signs of impending disaster in the pre-crisis economy-booming housing prices, a drastic underpricing of liquidity in asset markets, the emergence of the shadow banking system, the declines in lending standards, bank capital, and the liquidity ratios-were not given the priority they merited, because, unlike low and stable inflation, they were simply not identified as being relevant.”

India currently suffers from high inflation and not low inflation. But while deciding on a policy all factors need to be kept in mind. And the view in the Western world now seems to be that inflation targeting was one of the major reasons for the real estate bubbles that led to the current financial crisis. The RBI needs to keep this in mind.

Also, the bigger question about whether the RBI can play a role in curbing inflation continues to remain. If one looks at the consumer price inflation index, food and fuel items constitute 57% of the index. RBI’s interest rate policy cannot play any role in curbing the prices of these two items.

As Chetan Ahya and Upasana Chachra of Morgan Stanley Research write in a report titled Where Are We in the Boom-Bust-Adjustment Cycle? dated January 16, 2014, “high rural wage growth has also been a key factor behind the bad growth mix. We believe the national rural employment scheme (NREGA) has been one of the key factors pushing rural wages without matching gains in productivity. Rural wages have shot up since just after the credit crisis from early 2009, when the full implementation of NREGA started showing an effect. The rural wage growth rate moved up from 10-13% in 1H08 to an average of 18.7% over the last three years - without a matching increase in productivity. In our view, this has been one of the key factors resulting in higher food, services and overall CPI inflation as well as inflation expectations.”

Hence, the only way the food inflation and in return the consumer price inflation can be controlled, is if the government decides to control its fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. The RBI cannot play any role in this, other than suggesting to the government that its fiscal deficit is high.

(Vivek Kaul is a writer. He tweets @kaul_vivek)