Historically, inflation-targeting was popular with the central banks and international institutions for more than a decade, but only until 2008. In view of the recent financial crisis and rethinking of the economic strategies that went wrong before 2008 compels one to conclude that the role of economic blinkers that inflation-targeting imposed on the policy makers cannot be ignored in the great recession. It is for this precise reason that no new country has implemented inflation-targeting in recent years. In the case of India, there are a few more compulsions that need to be addressed. The most important consideration are supply-side constraints that contribute to inflationary pressures which cannot be addressed by the instruments wielded by RBI, especially for food items and fuel.
The food situation in general is grim, both in India and globally, and therefore, food prices are expected to be firm. The El Nino impact on monsoon is expected this year, affecting countries like India, Australia, Thailand, Indonesia, Vietnam, the Philippines and China, amongst others. The climatic pattern in India is also changing and the Centre has already cautioned the state governments to be prepared for the El Nino effect. In view of the fact that food prices are dependent on monsoons, such climate change phenomena are expected to put pressure on food prices. In addition, food prices are also impacted by the minimum support prices (MSP) prescribed for foodgrains which are under pressure for revisions, despite having risen significantly in recent years. The Food Security Act, 2013, (FSA) which has assured subsidised grains to nearly 80 crore people in the country is also expected to distort food prices. FSA has already begun to change the cropping pattern implying that land under grain cultivation will increase at the cost of other agricultural products, including vegetables. This is on the top of the shrinking of land availability for agriculture on account of expanding urbanisation. The stagnation in production of pulses, meat products and milk would also place pressure on food prices. Further, in India, given the demographic factors and increasing demand for protein-rich food would cause persistent pressure on food items. The populist measures, like increase in dearness allowance and number of guaranteed days of employment under MGNREGS, expected in an election year will increase demand, thus pushing up prices. The expansion of the Green Revolution in the North East, recently envisaged by policymakers, will yield results only after a gestation lag. So, supply-side relief will also be scarce.
In the CPI, weight of food is 47.58% for CPI-combined, 35.80% for CPI-urban and 56.58% for CPI-rural. In addition, food prices were also impacted by fuel prices, and the weight for fuel and light is 9.49% in CPI-combined, 10.42% in CPI-rural and 8.40% in CPI-urban. Thus, the weights of food and fuel together account for more than 57% of CPI-combined and 67% of CPI-rural. Hence, the pressure to contain the overall price level in CPI-combined would be significantly large for non-food and non-fuel items. Inflation-targeting in such regime would imply that when food prices increase, the prices of manufactured, services, housing and other miscellaneous items would need to decline.
Another aspect is the lack of critical appreciation of supply-side constraints. To illustrate, recently, when onion prices were shooting up, an influential segment of population was happily concluding that farmers, an important vote-bank, are the beneficiaries. The recognition of causes and economic implications of such onion episodes is lacking in policymaking. There is no doubt that the formal and informal sectors are interconnected and therefore moneylenders/hoarders are not insulated from the tightening monetary policy. But the extent of this connection, in view of the thriving unofficial sector, is not clear. Consequently, rate hikes only impact the organised sector, directly impacting growth and unemployment.
In view of the fact that prices of food grains are fixed by non-economic and political reasons, adopting an inflation-target would only distort the market mechanism while mainly impacting the prices of other goods and services. If the interest rates are raised considering the prices of other goods and services, it would adversely impact development of the economy as is evident by low growth of 4.7% during October to December 2013. Therefore, recommendations of the Patel Committee need reconsideration.
The author is RBI Chair professor of economics, IIM-Bangalore