On inflation targeting, in the years leading to the (global financial) crisis, central bankers had nearly declared victory. They had found the holy grail of stable growth, low inflation and low unemployment through a rule based monetary policy that targeted inflation rather than monetary aggregates. The much celebrated Great Moderation had delivered. The crisis at once hurt the central bankers? pride and shattered their confidence as the Great Moderation unravelled. Monetary policy was found wanting in delivering financial stability. The undoing was the reluctance or failure of central banks to acknowledge increasing asset prices.
The monetary stance of studied indifference to asset price inflation stemmed from the now notoriously famous Greenspan orthodoxy … The Great Unravelling has, however, shattered the intellectual consensus around both inflation targeting and the Greenspan orthodoxy on asset price build up. The crisis has made two things clear. First, the policy of benign neglect of asset price build up has failed. Second, price stability does not necessarily deliver financial stability.
Where do we in India stand on inflation targeting? Over the last few years, there has been an animated debate in India on inflation targeting fuelled by two influential studies, one by Percy Mistry and the other by Raghuram Rajan. While Mistry strongly urged that the gold standard for stabilising monetary policy is a transparent, independent, inflation-targeting central bank, Rajan held that reorienting RBI towards inflation targeting will have to dovetail with the government?s commitment to maintain fiscal discipline and not hold the central bank accountable for either the level or the volatility of the nominal exchange rate.
The debate on inflation targeting in India has to some extent been overtaken by the learnings from the crisis. Nevertheless, it is worthwhile noting that inflation targeting is neither desirable nor practical in India for a variety of reasons… First, it is inconceivable that in an emerging economy like India, the central bank can drive a single goal oblivious of the larger development context. The Reserve Bank must be guided simultaneously by the objectives of price stability, financial stability and growth.
Second, food items which have a large weight (46 – 70%) in the various consumer prices indices are vulnerable to large supply shocks, especially because of the vagaries of the monsoon, and are therefore beyond the pale of monetary policy. An inflation targeting RBI cannot do much to tame a supply driven inflation except as a line of defence in an extreme situation. Third, which inflation index do we target? In India, we have one wholesale price index and four consumer price indices. There are ongoing efforts at a technical level to reduce the number of consumer price indices… But that still will not give us a single representative inflation rate for an emerging market economy with market imperfections, diverse geography and 1.1 billion people.
Fourth, the monetary transmission mechanism in India is impeded because of the large fiscal deficits, persistence of administered interest rates and illiquid private bond markets… Finally, we need to manage the monetary fallout of volatile capital flows that queer the pitch for a single focus monetary policy. A boom-bust pattern of capital flows can lead to large disorderly movements in exchange rates rendering both inflation targeting and financial stability vulnerable. Like other emerging economies, India too will have to navigate the impossible trinity as best as it can.
In a more global context, given the fallout from the crisis, to ask how central banks should revert to their sole inflation targeting mandate is the wrong question. The right question is this: what are the specific roles and responsibilities of governments and central banks in ensuring price stability, financial stability and macroeconomic stability?
This is an edited excerpt from the JRD Tata Memorial Lecture delivered at the meeting of The Associated Chambers of Commerce and Industry of India, New Delhi, on July 31, 2009