Column : Inflation targeting hardly works

Written by Saugata Bhattacharya | Updated: Dec 12 2012, 06:55am hrs
The RBI Governors reported statement intending to revisit the theoretical framework of the oft-stated sustainable inflation level of 4.0-5.5% prompts the question: Why is Indias inflation, in relation to its actual or potential growth, continuing to remain persistently high, while many of our emerging market (EM) peers seem apparently to have lower inflation After all, almost all emerging economies face the same global commodity prices as inputs, and the increasing turnover on domestic commodities exchanges also serve to transmit global prices to domestic.

First, is the perception correct at all The accompanying table shows the growth-inflation profiles of some EMs, a crude measure of Phillips Curve trade-offs. The intent is to highlight the level of inflation relative to growth, rather than just the absolute levels of inflation. Two patterns emerge. One, adjusting for growth, Indias inflation does not look completely out of line compared to at least some of the other EMs in terms of differentials between CPI inflation and GDP growth. Two, it does seem that the selected countries are clustered into two broad groups with high and low inflation differentials. Might there be some underlying macroeconomic reason for this behaviour Note that the three countries with the higher inflation differentials were also those with the worst performing domestic currencies (see graph), indicative of large current account deficits, which will affect the extent of pass-throughs of global commodity prices.

For the moment, set aside domestic factors (aggregate demand, capacity utilisation levels, etc), even measurement issues (i.e., our own year-on-year change versus the annualised month-on-month change methodology using deseasonalised data used in some of our EM peers). Many hypotheses have been put forth for the different extent of pass-through, in terms of the openness of the respective economies, the degree of dependence on external energy sources, the movement of the domestic currency against predominantly the US dollar (in turn a reflection of macroeconomic imbalances, particularly current account deficit). But there has been no systematic attempt to understand the underlying drivers of the differential pass-through.

An IMF paper published recently* helps in providing an analytic scaffold of this differential, by relating inflation to a range of structural characteristics and policy frameworks in different countries over the period 2001-10. This article aims to familiarise readers with the main findings of the paper and, at a later stage, elaborate on Indias congruence with the results, at different time intervals in the past. In particular, is it time to revisit the effectiveness of inflation targeting as a policy response to inflation control The findings, broadly, are as follows.

Developing economies are more exposed to commodity price shocks than developed ones (which might be due to lower capacity slack), particularly for food prices and to a lesser extent to fuel prices (reflecting price controls and subsidies). Unsurprisingly, countries with high food and fuel intensities are more exposed to food and oil price shocks, although the extent of pass-throughs are not fully explained by the coefficients. Surprisingly, many variables, which economic theory suggests could have been significant, were apparently not: financial development (via effectiveness of monetary policy), labour market flexibility (through wage controls), or trade openness.

Even more surprising is that the effect of inflation targeting is, if anything, modest. The presence of inflation targeting regimes, in particular, was ineffective during the food price shock of 2008. The authors emphasise though that this does not mean that monetary policy credibility does not matter; in fact, the coefficients of central bank independence and higher governance scores in explaining the pass-through of commodity price shocks are significant. The authors infer that overall confidence in institutions is more important than a formal declaration of inflation targeting.

What comes out strongly is the effect of persisting inflation. Countries with high pre-existing inflation are more vulnerable to commodity price shocks. A plausible explanation is the effect of inflation expectations, with firms responding to cost increases by raising prices.

What are the implications for India of these results First, many of the identified structural characteristics shown to be factors in cost transmission, one of which is the extent of fiscal dominance, have been regularly flagged by RBI in its analytic underpinning of monetary policy. Imbalances in these characteristics will have to be mitigated. At the same time, the effectiveness of monetary policy in controlling inflation might be less than is currently presumed.

* Gelos, Gaston & Yulia Ustyugova, 2012, Inflation Responses to Commodity Price ShocksHow and why do countries differ, September, IMF Working Paper No 12/225

The author is senior vice-president, business & economic research, Axis Bank. Views are personal