Growth targeting: Should the monetary policy framework be reviewed?

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Updated: March 29, 2019 7:15:33 AM

Creating a new price index that aligns with the GDP composition is the only way to make monetary policy effective as it can curb excess demand forces across the economy

MPC framework, CPI inflation, MPC, inflation index, monetary policy, monetary policy frameworkUsing the CPI for tackling inflation through monetary measures runs the challenge of targeting a number over which monetary policy has little control.

Is it time to revisit the mandate of the MPC? The MPC had to target CPI inflation at 4% within a band of 2% on either side. Over the last two years or so, interpretation became hard for the market as different decisions and stances were taken on this number based on the distance from this norm. Further, inflationary expectations, too, kept the market guessing as policy outcomes would be different based on the same conjectures. To top it all off, the MPC also provided a stance which could be viewed as either neutral or one of calibrated tightening. The earlier lament of slow transmission exists even today. And, above all, singular targeting of inflation had, at times, led to growth being given a pass which was a view expressed by industry. It may hence be useful to relook at the principles.

Certain questions need to be posed. Firstly, is the CPI inflation the best inflation index to target or should we look at another indicator? Secondly, how often can the stance of policy change and can it be parameterised? Thirdly, should there be an inflation forecast every two months or should it be not more than twice a year? Fourthly, should growth enter the mandate of the MPC so that it is not just inflation that is being targeted?

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Using the CPI for tackling inflation through monetary measures runs the challenge of targeting a number over which monetary policy has little control. The weight of food items in this index is 46%, which is not affected by interest rates as rarely does one borrow to buy food. Other components like clothing, rent, medical, entertainment, education, fuel, etc, also are not driven by credit. Therefore, in a situation of rising inflation, increasing the repo rate with very good transmission is unlikely to bring inflation down.

The anomaly is stark when one looks at the factors that drove core inflation up in recent months. Rent is actually reckoned on the basis of cost of government employees that went up due to the Pay Commission’s recommendations. It is notional and is not reflective of inflation per se. More recently, the health and education indices increased which also cannot be tackled by monetary policy. These charges get revised periodically where fees of professional institutes are increased as are medical service charges.

The WPI is always a better inflation target because it is influenced by cost of funds as around 64% of its weight resides in manufactured goods. It, however, excludes services which can add to inflation as has been the case with the rent, health and education indices. Alternatively, it may be useful to create a new price index that reflects all sectors and aligns with the GDP composition (see attached graphic). This is the only way to make monetary policy effective as it can curb excess demand forces across the economy. Presently, most of the inflationary impulses emanate from the supply side where costs increase.

The stance of the policy has come to be interpreted as the possible change of direction in the coming months. Ideally any ‘stance’ should remain for some time unless there is a shock of an immense nature. The idea of a stance is that it has to be forward-looking and a precursor of future action taken before the change is invoked. Presently, there has been a tendency to make a change in rates accompanied with a change in stance which then makes the concept of stance amorphous. The third part of the policy is the inflation forecast. Can the forecast change every time the policy is announced? Ideally, such forecasts should be once or twice a year with the second one being a review along the way. The forecasts cannot be changing every two months, especially if there is a range being provided. Constant changes in forecasts cause volatility in the market that then tries guessing future rate actions as these forecasts have had a bearing on policy.

Curiously, ever since the monetary policy framework has been put in place, by a matter of coincidence, inflation has remained low at around 4% which was not the case earlier when CPI witnessed successive increases in the range of above 8% (2009-13). The policy, stance and forecasts have worked well so far as the inflation number has gravitated to 4% with the market guessing whether rate cuts happen when actual inflation comes down or expectations come down. It would be interesting to see how rates react when inflation soars, which is possible if there is a monsoon shock or oil prices start moving up.

The last consideration is whether inflation targeting should be the only variable that is looked at or should growth be as well. It has been seen that the critique of monetary policy has often had political language that borders around obsessions with inflation to the neglect of growth. If that is the case, should there be change in the legislative action that also includes growth as a variable to be targeted? It may be recollected that, in the past, monetary policy always spoke of growth and inflation and while there was no overt target for inflation, the general direction of movement of prices provided a clue on what the policy would be like.

The growth versus inflation dilemma has also been witnessed in the US where its president has been vocal in pointing a finger at the Federal Reserve. It is normally believed that interest rates are a panacea for growth. But this did not quite work out post the financial crisis where the Fed had to resort to unconventional measures to stimulate growth through quantitative easing programmes. If it is to enter the frame then, it would be necessary to state specific numbers that have to be targeted, which can be 7.5% or 8%. But then, balancing the two targets will be more complex.

Quite clearly, there is a need to revisit the framework. Firstly, the economic conditions have been quite congenial so far and have not tested stressful positions. Hence, if inflation starts going up due to a bad toor crop, and inches towards 6%, should there be a series of increases in rates? Further, if inflation moves towards 10%, then should the repo rate be closer to 8% or 9%? These questions would arise when the situation gets sticky. Secondly, the current battle against inflation is out of sync with the power of monetary policy. Higher rates cannot change prices of food, or medical treatment or education or rent. Therefore, a new index can be considered. Thirdly, continuous revisions in forecasts of inflation can create uncertainty in markets and hence should be limited. Lastly, some growth perspective should also be part of the monetary policy package if the government feels it is important.

The experiment, so far, has worked well under virtually no stress conditions. It may be useful to revisit the framework and make alterations if required to make it more inclusive. This would mean moving away from exclusively being monetarist to the neo-classical.

The author is Chief economist, CARE Ratings. Views are personal

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