Inflation-targeting (IT) frameworks have gained widespread popularity among global central banks over the last few decades. According to IMF, as of October 2016, 38 countries had officially adopted an IT framework—10 advanced economies (AEs) and 28 emerging market and developing economies (EMDEs), India being one of them.
India, like most other countries, operates an IT framework flexibly to accommodate other objectives, including growth/unemployment and financial stability. Can a flexible IT regime with a single instrument (usually the interest rate) adequately accommodate multiple objectives?
In principle, the answer is yes for at least two reasons. One, if an IT framework is operated loosely—in the sense of having a wide inflation band (+/- 2% for India), longer-time horizons within which the inflation objective should be hit (effectively three consecutive quarters for India), or more escape clauses (i.e. exceptional circumstances which might preclude inflation objective being met)—this flexibility allows the pursuit of other non-inflation objectives. Nonetheless, too much flexibility could also create confusion and impact communication of the central bank.
Two, at times there could be “divine coincidence” in the sense that a single policy instrument (repo rate for India) could hit multiple objectives simultaneously. For instance, if there is a capital inflow-induced boom in overall growth, leading to inflationary pressures, and asset price surges that could threaten financial stability, then an interest rate hike would be an appropriate policy instrument that could help achieve all three goals of non-inflationary growth and financial stability.
However, what if the objectives are at logger-heads? For instance, the country might experience sluggish growth along with stable inflation but an asset price boom that threatens financial stability? In such an event, interest rate hikes to reign in asset prices would exacerbate the domestic downturn and threaten the macroeconomic outlook.
Thus, absent divine coincidence, we should recall the classic Tinbergen rule which states that there must be at least as many instruments as there are objectives. In an ideal scenario, the so-called assignment problem suggests that, in the event there are policy trade-offs, inflation should be the primary focus of monetary policy. While growth and employment should be the prerogative of fiscal and structural policies, the goal of financial stability can be tackled via macroprudential measures that are designed to limit systemic vulnerabilities by focusing on the entire financial system.
Flexible inflation-targeting and exchange rate flexibility
For EMDEs, there is arguably an additional objective beyond inflation, growth and financial stability, viz. a degree of exchange rate stability. There are two dimensions to exchange rate stability: managing volatility versus preventing misalignment. The former is not controversial and is not inconsistent with an interest rate based IT framework. It is used by both AEs and EMDEs operating an IT regime.
Somewhat more controversial is the idea of dealing with misalignments. Why should countries with an IT framework pay heed to the exchange rate movements? There are two broad concerns in this regard.
One, for EMDEs, the exchange rate is too important for the macroeconomy and the interest rate transmission is not entirely effective for various reasons, including financially impaired banks, underdeveloped financial markets and instruments, and lack of financial inclusion.
Two, there remains an ongoing concern that exchange rate changes/misalignments impact the domestic economy in ways not easily captured in available macroeconomic models. These effects include wealth and balance sheet effects due to US dollar borrowing/foreign exchange exposure, hysteresis or permanent negative effects on exports due to persistent overvaluation, changing extent of and asymmetries of exchange rate pass-through to inflation, and so forth.
In view of the significant but rather complex impacts that exchange rate changes have on the domestic economy on the one hand, as well as the incomplete pass-through of interest rates to the macroeconomy on the other hand, managing the exchange rate is an additional objective that has been pursued by many other East Asian countries that have operated flexible IT frameworks.
Specifically, many of them continue to lean-against-the wind when the exchange rate strays too far from levels that are inconsistent with medium-run fundamentals. The key point to note here is that managing the exchange rate in response to possible sharp deviations from “fair value” does constitute currency undervaluation as long as foreign exchange intervention is done symmetrically. Currency undervaluation can’t be a substitute for the government addressing domestic bottlenecks that hinder exports and investments.
Broadening RBI’s evolving policy toolkit
In some circumstances—divine coincidence—interest rate as a single instrument can hit multiple objectives. For instance, when there is inflationary pressure and a depreciating currency, one can raise interest rates. But what if there are domestic boom/inflationary concerns and capital inflows-induced appreciation? Should the central bank raise or lower interest rates?
Absent international policy coordination, and if countries decide against countercyclical use of capital controls, EMDEs like India are not helpless. They have at their disposal sterilised foreign exchange intervention with the goal of insulating interest rates from the effects of foreign exchange intervention. While such a form of intervention may not be very effective in AEs, in EMDEs that are often characterised by imperfect asset substitutability and imperfect capital mobility, sterilised intervention remains a viable policy tool.
In general, therefore, RBI, like some of its East Asian counterparts, should focus on flexible, but not “too flexible”, IT. It should aggressively use macroprudential regulations but ensure that incentives for, and the ability to undertake, regulatory arbitrage are minimised. RBI should also be willing to undertake sterilised intervention when exchange rate movements appear inconsistent with fundamental changes, though making sure never to regress to exchange rate pegging.
In the final analysis, RBI needs to pay attention to many dimensions of economic performance and financial stability using a broad array of tools but always maintain and communicate the primacy of the inflation target.