Column: At what cost to growth

Updated: Mar 25 2014, 06:24am hrs
The Urjit Patel committee report to revise and strengthen Indias current monetary policy framework recommends a shift to inflation-targeting (IT). It is felt that an IT regime, in which inflation becomes the predominant objective, will make monetary policy more transparent and predictable. It presents a two-year period of disinflation ending in the formal adoption of IT with a 4% CPI inflation target and a 2% deviation band on either side. The transition path to this target zone is graduated to lower inflation from its 10% levels to 8% in the first year, followed by a two-point reduction to 6% the year after. An informal transition began this January with RBIs adoption of CPI as nominal anchor and policy rate adjustment towards achieving an 8% target in the next 12 months.

Our concern is with the costs of disinflation should the Patel committees proposals be accepted. The case for IT rests on two academic insights: Friedmans claim that there is no long-run trade-off between inflation and growth; there may be a short-run trade-off where higher growth can be obtained with higher inflation as the cost, but the two are independent in the long-run. Since output is beyond the control of central bankers, they should focus on what they can, i.e. inflation. Because a short-term inflation-growth trade-off may tempt a central bank to occasionally favour growth (Kydland-Prescotts dynamic inconsistency), an IT regime seeks institutional structures binding central banks to commit to a low inflation target acceptable to the public. Once a belief that inflation will remain low is established, public confidence that the medium-run inflation outlook will not change much even when shocks occur will follow. IT works through a stable, predictable link between the policy rate and the inflation rate, with rule-based monetary action (Taylor rule).

Thus, growth and employment matter in IT only to the extent that a commitment to a medium-term inflation objective remains credible. The weights on inflation are larger and increased vis--vis those on growth in IT. Building credibility by successfully meeting pre-announced inflation targets requires greater effort in the early stages if the credibility bonusviz well-anchored inflation expectations that then allow some wiggle room to temporarily breach/increase inflation targets without realising actual inflationis to be reaped later. So, even though operationally IT works more flexibly as constrained-discretion than a strict rule, potential disinflation costs in terms of growth sacrifice due to stronger interest rate responses under an IT regime are a concern.

Given the belief of no long-run trade-off between inflation and growth, the Patel committees focus is the negative impact of prolonged, high inflation upon growth via real exchange rate appreciation and savings-investment imbalances. What is the international experience on growth outcomes under IT however Did countries that adopt IT in the past 20 years suffer output losses as a result

Empirical evidence for emerging markets (EMs) on the cost of disinflation is overwhelmed by the fact that IT was widely adopted during what is now known to have been an exceptionally benign economic environment of low, stable inflation combined with steady economic growth, the Great Moderation phase that ended in 2007. The causes of this reduction in macroeconomic volatility are not fully identified. Whether macroeconomic shocks were simply smaller due to good luck, or if better policies including IT, promoted stable growth and low inflation, is an unresolved issue. What is unmistakable is Chinas high, sustained growth rate in this period, which sparked a long commodity prices boom that fuelled rapid growth in commodity-exporting EMs, many of whom shifted to IT; strong growth facilitated sharp reductions in net public debt-GDP ratios, amongst other things. Disinflation costs are blurred in this setting, studies conclude, as it possibly allowed looser monetary policies than otherwise might have been the case.

Post-crisis, the macroeconomic environment is sharply adverse. Macro financial volatility is high and global growth lower as China permanently grows at a lower rate; the advanced countries see a low-level recovery; while EMs growth is pulled down by a combination of reduced demand from major trade blocs and a tightening US monetary cycle. Larger shocks of the post-crisis period provide a useful counter-factual for IT therefore. An aggregate overview by BIS economists (see table) of pre- and post-crisis performance for IT and non-IT regimes shows that on average, non-targeter EMs enjoyed faster growth rates of 7.13% (2000-06) and 4.13% (2007-12) compared to targeter-EMs, who grew more slowly (4.51% and 3.65%) in comparison, especially pre-crisis.

Direct, country-specific econometric assessments are few, while cross-country studies are mostly inconclusive due to different samples, time-periods, control groups and methodologies. A 46 developing countries panel study controlling for common time effects shows robust evidence of lower output growth during IT adoption; though lower long-run mean inflation signals that IT central banks are more inflation-averse, the costs of disinflation have not been lower than under other monetary regimes. A smaller sample study (8 developed, 13 developing countries) finds no growth sacrifice under disinflation for developing countries but significant losses for developed ones.

The sharp shock implied in an IT frameworkstronger interest rate responses from increased weight on inflation stabilisation and reduced weight on real economic stabilityto break the self-supporting vicious circle of rising inflation and its expectations that coexist with a persistent output gap thus invites concern about costs to growth. It is compounded in the Indian context because the recommended shift to IT is coincident with change in nominal anchorfrom producer price to consumer price inflation. The differential inflation rates faced by producers (WPI) and consumers (CPI) mean much higher real interest rates for the former segment, and for whom the magnitudes and elasticities of credit demand vis--vis interest rate changes are much bigger. An adverse disinflation impact upon investment and growth cannot be ruled out hence. A debate on these aspects should precede acceptance of Patel committees recommendations.

Renu Kohli

The author is a New Delhi-based macroeconomist