Monetary policy: Why RBI should not just target CPI, but asset price changes too

The monetary policy framework proposed by the Urjit Patel Committee has set the proverbial cat among the financial pigeons. Some commentators have claimed it is intellectually obsolete even as others defend it.

In a recent article, Ajay Shah of the National Institute of Public Finance and Policy (NIPFP) weighed in on the latter side and favoured the inflation targeting framework recommended by the report. This defence is based on two premises. The first is that all currencies need a nominal anchor, and the second, that only three possibilities exist for such an anchor; gold, a foreign currency and the consumer price index (CPI) basket of goods.

While the first premise cannot be contested, the second has some characteristics of a false dilemma. The article elucidates arguments against a foreign currency anchor well, but other than mentioning that the gold standard failed, it neglects to explore the reasons for its failure. In doing so, it misses the existence of a fourth possibility.

Monetary policy measures impact both consumer and asset prices. Any nominal anchor that targets one to the exclusion of the other goes only half way in providing true price and macroeconomic stability. The gold standard was particularly flawed in this context because it targeted the price of one asset to the exclusion of all other assets and consumer prices. As a result it failed to compensate for deflation in consumer goods and other assets during the Great Depression era resulting in widespread macroeconomic grief and its eventual demise.

Targeting the CPI basket is definitely superior to the gold standard inasmuch as it targets the composite price level of a wide range of consumption items instead of just one. However, by ignoring asset prices completely it introduces a possibly fatal flaw into the framework, manifestations of which are increasingly visible over the last few decades.

The CPI targeting framework in the USA (informal, but very much in place) has resulted in violent asset boom and bust cycles in the 35 years of CPI stability. In addition, its position in the global economy has transmitted the ill effects of these cycles across borders, the latest of which almost brought the global economy to its knees. As such, the CPI inflation targeting framework’s success in providing unparalleled consumer price stability has been accompanied by its spectacular failure in providing asset price and macroeconomic stability.

So while it is clear that CPI inflation targeting as a monetary policy framework has its benefits, it is equally apparent that it has severe shortcomings as well. Shortcomings which have the potential of wreaking widespread macroeconomic havoc, pretty much like the gold standard.

This is where the fourth option comes in. For monetary policy to contribute significantly to macroeconomic stability, it is essential that its framework include a nominal asset price anchor as well. In its formal manifestation, this may take the form of an asset price index for each nation with its own mix of pertinent asset categories. Such an index would necessarily include real estate in all forms; undeveloped land and buildings, both commercial and residential, etc. It would also necessarily include stock prices.

It may include gold in a country like India, where it is an essential ingredient in the generic investment mix. It may also include the foreign currency rates of leading trade partners and competitors, if one wishes to widen its scope, with appropriate safeguards since this may result in complications and self-fulfilling cycles.

As in the case of the CPI, constituents and their weights will differ from one nation to another. In addition, the relative importance assigned to such an index will reflect each nation’s unique economic circumstances. The manner in which the two indices are used may also differ. Some nations may choose to create a composite national price index with appropriate weights assigned to consumer and asset prices and use this index to guide monetary policy. Others may choose to let one guide monetary policy direction with the other merely exerting an influence on the magnitude of resulting changes. Also, given the relatively discontinuous nature of asset price movements compared to consumer prices, the use of longer term moving averages may be considered.

An analysis of the US Federal Reserve’s monetary policy decisions since 2008 and, especially in the last few months, indicates that a similar thought process may already be in place. While this has no formal underpinning at the moment, it would serve to explain some of the more surprising decisions taken over the last few years and months much better than the official narrative of inflation and unemployment.

While it is apparent that the basic intellectual underpinnings of the monetary policy framework suggested by the Urjit Patel Committee are robust and current, the mechanism may be a bit dated. Every currency does need a nominal anchor and domestic prices are eminently suited to providing this anchor. However, there is now considerable evidence that a monetary policy framework targeting just consumer prices has critical gaps. These gaps can only be filled by the inclusion of asset prices.

It is possible that moving away from a sole focus on CPI may cause larger and longer lasting differences between target and actual consumer price inflation. However, whatever is sacrificed in terms of consumer price stability is more than compensated in terms of long-term macroeconomic stability. And when it comes to a choice between consumer price stability and macroeconomic stability, the latter is a very obvious winner.