Is inflation-targeting the way to go

Written by Soumya Kanti Ghosh | Updated: Jan 28 2014, 11:00am hrs
The Urjit Patel committee recommendations on inflation-targeting are a bold attempt. The arguments for recommending CPI as a nominal anchor and setting a 2-6% CPI target in the medium term are welcome, and can be seen as a sincere endeavour against the backdrop of a stubborn inflation since FY11. However, in the contours of a developing country like India, the success of inflation-targeting may remain elusive.

In the aftermath of the financial crisis, the focus of central banks has shifted to financial stability instead of inflation-targeting. The US Fed adopted unemployment as a secondary objective underlying the concerns to growing unemployment situation. Bank of England advocated use of nominal GDP as a target; Bank of Japans monetary policy statement advocates targeting a higher rate of inflation.

This apart, though inflation-targeting has benefits like reducing the time-inconsistency problem of monetary policy, enhancing the credibility of a central bank and anchoring inflation expectations, offering more flexibility, the empirical evidence of its impact on inflation performance is ambiguous.

One of the justifications in the Patel committee of targeting retail inflation is the fact that countries like Indonesia and Brazilthat have a relatively significant fraction of food and fuel in the CPI basket (close to 40%)chose to target headline CPI. Within the BRICS (excluding China and Russia), South Africa and Brazil target inflation but do have a higher consumer debt-to-GDP, an essential prerequisite for enabling transmission mechanism (ditto for Indonesia). Even China, that is not doing inflation-targeting, has a household leverage ratio at 32%! In India, the household leverage is 10% at macro level. In the UK, mortgage interest payments have been included as an item in CPI through a rigorous modelling exercise to make the transmission mechanism more effective (absent in India).

The report points out that the level of CPI-combined inflation above which it is inimically harmful to growth is 6.2%. If we take this as the threshold rate of inflation and juxtapose this with a 4% CPI target, it implies that the recommendations may have a built-in bias of being deflationary. By this logic, the band could have been built around a mean of 5-6%, with the deviations centred around such a mean. The 4% CPI target may also imply a WPI at 1.5% (the average CPI-WPI gap has been 2.5% and above), which assumes core WPI and CPI numbers at historic lows.

The committee has made recommendations regarding the constitution of a separate MPC to delegate the monetary policy decision to monetary policy experts. But we believe that the composition of MPC as mandated in the Patel committee report may have been more broadbased, with even representation from the government (akin to the UK) to have better monetary and fiscal policy interlink age. In most countries, the government is also represented on the decision-making body. In India, given the sustained fiscal dominance and the significant presence of informal finance, a good way to make the MPC more effective is to have a government nominee on the committee.

The report has recommended the real policy rate to be positive. This implies that rise in inflation above the expected rate will automatically lead to rise in the policy rate. However, more crucially, to what extent the real policy rate has to be kept positive is not exactly specified for alternative phases of the business cycle. We believe that in India the interest rate might have some influence on saving but the influence of changes in national income may be an additional factor determining the aggregate level of savings in any period (in FY10, real interest rate was at negative 5.5%, savings rate increased by 21.1% and disposable income by 14.7%).

On the whole, the recommendations of the report are bold, but will require the concerted effort of all stakeholders to take it forward.

The author is chief economic advisor, SBI. Views are personal

The much-awaited Patel committee report has recommended significant changes to the existing framework of monetary policy in India. The exhaustive list of recommendations serve as a medium-term statement of intent from the Reserve Bank of India (RBI). The basic premise of migrating from a multiple indicators-discretion based policymaking to a rule-based policymaking designed around a defined nominal anchor will enhance policy predictability, credibility and accountability.

A move towards inflation-targeting is in sync with global best practices and is essential for a stable economic regime. The eventual target of 4% CPI inflation is found to be in accordance with the concept of zero output gap with the wide band of plus/minus 2% around the actual target providing requisite flexibility to the RBI for fine-tuning its monetary policy as per local requirement.

That we need inflation-targeting, albeit a moderately flexible one, can hardly be debated. We can ill-afford a tag of being a high inflation economy. Persistently elevated inflation has distortionary effect on savings behaviour and export competitiveness. It also erodes appetite for investment and can potentially lead to gross misallocation of financial resources. The decline in actual output over last two years can also be attributed to high inflation scenario, among others.

The success of the new monetary policy framework, however, is premised on meaningful fiscal consolidation backed by serious structural reforms with respect to subsidies, approach towards disinvestment, rapid implementation of GST, among others.

In this context, the time frame over which the policy framework is designed to be implemented seems a little ambitious, as getting to a 3% fiscal deficit-to-GDP ratio in two years seems challenging. This, however, should not serve as an excuse to dilute the far-reaching positive impact that the new monetary policy framework envisages to achieve, i.e. if we still aspire to growth by 8%-plus over the medium term.

In addition, fiscal and political coordination towards phasing out existing subventions and administered pricing along with development of financial markets (both deepening and widening) is an imperative.

While we believe majority of the recommendations could get the governors approval for implementation, the process of implementation per se is likely to be a gradual one, considering the required amendments to the RBI Act.

Other recommendations such as the focus on developing the term repo market is already a work in progress. Recall, RBI started term lending from October 13 onwards. Since then, nearly one-third of the liquidity requirement of banks is being met through this channel, with the remaining two-thirds being met through liquidity adjustment facility (LAF), marginal standing facility (MSF), and export credit refinance (ECR) windows.

In the short term, this points towards the likelihood of a continuation of the borrowing cap on the LAF window. In the medium to long term, the key benefit of the creation of term repo market is that it would cap the dependence of banks on overnight central bank liquidity and would thereby incentivise banks to access market liquidity.

Since price discovery in term repo market is superior, a fully developed liquid term money market would act as a basis for pricing of deposits and credit, thereby facilitating enhanced monetary transmission.

The Patel committee recommendations would serve well as a blueprint for taking the monetary policy framework forward towards greater global coordination but must be tailor-made for domestic requirements as well.

The author is senior president & chief economist, Yes Bank