Targeting inflation right

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Inflation may touch 10% by end MarchInflation up at 0.83% on higher food pricesHoarding drives food inflation by 16.32%Inflation a matter of concern: FM

: The RBI has added a new dimension to inflation. The usual 5-5.5% inflation rate which has been targeted in almost all monetary policy announcements has come down to 5% for FY08, and, more importantly, is to be contained at 4-4.5% in the medium run. This has been briefly justified on grounds of India being well integrated with the global economy, and there being a pressing need to pursue the goal of lower inflation. Is this a good idea?

Having a medium-term goal is an excellent thought especially when it is monetary policy as market participants are able to plan accordingly. The predictability of policy based on targeted inflation would guarantee an optimal solution. In fact, this is the stance taken by the Rational Expectations School where its proponents Lucas and Sarjent had argued that policies need to be known in advance for equilibrium. Such an approach may be viewed more as a reverse-rules policy advocated by Friedman and Phelps. Under a “Rules” approach, monetary authorities announce a monetary rate, say money supply growth, which they feel is consistent with an unemployment rate. Any excess monetary expansion is only inflationary. Here we are targeting inflation instead which has implicitly embedded monetary numbers.

But this policy needs to be credible and the RBI should not do a volte-face during this period and go in for a different target. This is so because the market would perceive that in order to reach an inflation number of 4-4.5%, the RBI would tinker with the CRR and repo rates accordingly. Hence, if inflation was reigning high, then logically, the RBI could be expected to come up with upward revisions. The converse would hold in case of low inflation.