The efforts of policy authorities to tamp down inflationary expectations have begun to appear Sisyphean. The news of a surge in global wheat prices, with worsening crop conditions in Russia, the large CIS countries and Canada, has also increased concerns that despite expectations of a good rabi harvest and large stocks of wheat in warehouses, wheat prices in India are going to remain stubbornly high. Crude has again touched $82 a barrel; base metals prices are ticking up, on just the hint, even hope, of a modest recovery in the developed world.
Different opinions have been expressed on whether RBI is behind the curve on its policy tightening trajectory, given the lags in the policy transmission channel that are informally conjectured (but vaguely quantified for India, although an IMF Working Paper has recently attempted an estimate). As a logical extension of these arguments, there is renewed debate on the issue of whether RBI should be an inflation targeting entity, instead of using the more eclectic multiple indicators mechanisms in determining policy.
The predominant responsibility of a central bank is clearly anchoring inflationary expectations, because it is very easy to set off a debilitating wage price spiral. To the extent that inflation is correlated with growth, the trade-off between growth and inflation is also analytically equivalent to using inflation as the primary target. In simple English, this means that if inflation is a demand-led phenomenon, then it is amenable to alterations by controlling the pace of growth.
So far, so good. But should a focus on inflation translate into an explicit inflation targeting? Economic conditions prevailing in high-growth emerging markets, on the whole, seem to argue against this. While the principle of a clean inflation target is appealing, the operational details of its implementation in a high growth emerging economy all but make it impractical. A pure inflation targeting central bank, like the Bank of England (BoE), for instance, has a clearly defined target set by the UK Treasury, which the BoE is supposed to implement with an independently chosen interest rate. While it is true that the BoE had managed to keep close to the target rates over much of the period since the inception of the mechanism, so too had other developed countries that did not use explicit inflation targeting, indicating that global structural features had a large role to play in the stable inflation scenario. Quite apart from the well-recognised, substantive issues in the measurement of inflation in India, there are questions regarding the basic principles themselves of inflation targeting in emerging countries. Analytics can be refined, data collection processes can be strengthened, but the underlying causes and drivers of economic processes cannot be wished away.
A rule-based inflation targeting mechanism hinges on certain assumptions of stability in the economic system. The first is that of a non-accelerating rate of unemployment (or output, NAIRU), which is often manifested in the use of Taylor Rule type of optimisations between the gap between actual to ?potential? output and the prevailing inflation rate. The recent paper by RBI economists has estimated a ?neutral rate?, but more analytic work needs to be done to establish the robustness of this estimate.
The second is the stability of the demand function of money. Short of sophisticated analytics, a quick eye-balling of the ratio of broad money to GDP indicates a distinct trend component, rendering the ratio non-stationary, but with a fluctuating slope.
Such statistical infirmities can certainly be tackled through filtering tools that are commonly available, but in the absence of a proper understanding of the contributions of the underlying components of money, the filters simply take away relevant information embedded in the original series. Even in developed countries, where their mature economies render greater stability to the underlying economic variables, a literature search will unearth the extreme variability in the empirical relationships between output and inflation, depending on the underlying assumptions used.
Based on these economic tradeoffs, next is the question of the transmission channels for policy signals. Given the continuing bank-centricity of credit flows, shifts in the spectrum of interest rates of bank loans are the predominant channel signalling the policy stance. Infirmities in various segments of the money markets, particularly term money markets, are known impediments, but they do not detract from the principle of inflation targeting. What does detract is the need for reasonably priced credit in emerging markets, to decongest the widespread supply bottlenecks that impart price stickiness in supply responses.
Finally, there are asset markets, whose prices are only impacted as second or third order effects of policy shifts. Although asset prices do respond to interest rates, interest differentials in India and pools and global capital are likely to create a complex interplay of funds flows, inducing indirect effects magnifying or weakening policy signals, even in the absence of full capital convertibility.
The experience of the financial crisis has reinforced the need to revisit each and every hypothesis, assumption and policy correlation. And an inflation targeting approach is among the most important of these. There might indeed be a case for using rule-based responses to inflation, but the case will need more reasoned development.
The author is vice-president, business & economic research, Axis Bank. Views are personal