The wrong target

Written by Charan Singh | Updated: Feb 4 2014, 09:00am hrs
RBI recently released the Report of the Expert Committee, chaired by deputy governor Urjit Patel, to revise and strengthen the monetary policy framework. As was expected from the terms of reference and the composition, it was clear ab initio that in line with the recommendations of the Mistry Committee (2007) and Rajan Committee (2009), India would soon have an inflation target of its own, to join the elite club of central banks like that of the UK, irrespective of the fact that advanced economic systems, with seamlessly integrated financial markets, only adopted inflation-targeting just about a decade ago. Our financial markets and institutions will at least take a decade, if not more, to reach that level of maturity, depth and integration.

First, it is fascinating to know that a central bank of a country, self-motivated, is seeking accountability for its actions. This is indeed rare, commendable and should be appreciated by the policymakers across the country. The Patel Committee report is a well-compiled document but deeper examination reveals that the review of literature is generally based on articles published before 2008. The reason is that since the global crisis, a few articles advocate inflation-targeting, a fact acknowledged in the report itself. Most of the countries adopted inflation-targeting before 2003. In addition to India, the following G20 countries do not have such a regime: Argentina, China, France, Germany, Italy, Japan, Russia, Saudi Arabia and the US, though many of them have well-developed financial markets. Hence, the hurry in implementing inflation-targeting in India is intriguing, given the last monetary policy announcement.

In sharp contrast, Bank of England (BoE) Governor Mark Carney observed in his speech on January 24 at the Davos summit: We wouldnt even begin to think about raising interest rates until the unemployment rate fell to 7%, doubtlessly not the conservative central banker Kenneth Rogoff wrote about (1985) but a prudent one for difficult times. A day earlier, Paul Fisher, executive director, BoE, had argued at great length as to why the UK central banks monetary policy committee did not tighten the policy to rein in inflation. He observed that tightening would have depressed the economy further by consciously pushing down output and employment. To quote: So, despite the costs of the inflation which were experienced, the costs of the policy needed to counteract it would have been even greater in this specific circumstance of one-off shocks and left the UK economy in a much worse position now But tightening policy in response would have been a major mistake: a tighter policy then and we could now be facing the threat of deflation and depression, rather than inflation around target and prospect of real recovery.

In India, fortunately for the members of Urjit Patel Committee, there is no robust data on unemployment. It is generally presumed that workers laid off as a consequence of slowing growth can go back to their larger families as there is disguised unemployment. But it has to be recognised that the concept of long- and short-run exists only in textbooks or for those with means to survive the grim short-run. In India, where there is no social security, unlike all the advanced western countries, people dont have the luxury to survive the short-run itself. The adage, we economists are so familiar within the long run we are all deaddoes not apply in poor countries, where a substantial portion of the unorganised sector workforce, survive on meagre daily earnings and cant save. Sacrificing growth, on the altar of ornamental inflation-targeting, which has a human cost, may not be good public policy in the year of an election.

Inflation-targeting was advocated for a long time by the IMF but after the recent global crisis the thrust has been moderated, probably because of the long planning horizon and uncertainty it entails. In the UK, the planning horizon is of nine quarters in advance. To achieve these projections, very sophisticated econometric models are used, seeking a number of variables and after intense expensive training of the staff, especially in dynamic stochastic general equilibrium models (DSGE). These models have their own limitations. Illustratively, how would the output gap be estimated nine quarters ahead in India IMF, which does it for India using DSGE, always gets it wrong. How can a country with less than 2% of global output and feeding one-sixth of the worlds population, whose fortunes are subject annually to weather gods, safely avoid imitating advanced countries accounting for stable output trends

There are a number of central bankers who believe that countries that did not follow inflation-targeting survived the global crisis rather easily. In India, where we are still searching for an appropriate price index, adopting such a regime may be rather premature. Inflation-targeting, even if flexible, would imply that the focus is on inflation, in sharp contrast to the multiple indicators approach which has been the hallmark of India, domestically minted by former RBI governors Jalan and Reddy and successfully tested during the Asian and the recent crises. Before unceremoniously abandoning the multiple indicators approach, we should have a public debate on inflation-targeting before implementing it in India.

The author is RBI Chair professor of economics,

IIM Bangalore