While inflation has been record-low since the inflation targeting framework was introduced, RBI alone cannot be credited for it.
By Shekhar Tomar
This week, the government appointed a new set of external members to the Monetary Policy Committee (MPC) of RBI. It gives us an excellent opportunity to analyse MPC’s functioning and its future. India is one of the major countries to jump on the inflation targeting bandwagon among the emerging market economies. As formal legislation, Parliament passed the inflation targeting (IT) framework in February 2015.
The idea behind IT is simple. A central bank commits to keeping inflation below a certain threshold and use every arrow in its quiver (usually there is only one arrow-the interest rate) to achieve this objective while maintaining growth. However, the change also involves a more systematic MPC meeting schedule and communication by the central bank to explain the rationale behind its decision-making. The former involves holding meetings on pre-announced dates while the latter involves public announcements by the central bank on its decision, the voting on rate decisions by the MPC members, and public release of the minutes of the meeting.
There is a wide array of changes that go when a country switches to IT. However, the ultimate goal of all of them is to convince the public about a central bank’s seriousness in upholding the inflation target. One of the key outcomes under IT that determines a central bank’s performance is its control over inflation. In India’s case, inflation reduced from a high of more than 10% before 2014 to a more comfortable value after IT. However, giving the entire credit of such reduction to the central bank is usually tricky. First, countries with very high levels of inflation (say India before 2014) are more likely to adopt IT, and are, therefore, serious about bringing it down. Maybe these countries would have decreased inflation even without an explicit IT regime. Second, food products form a large part of the consumer basket for countries like India. A stagnation in global/local food prices is once again going to reflect in low inflation, though without any intervention by the central bank.
We sidestep this problem by looking at bond and stock markets’ performance after the monetary policy announcements. If RBI’s monetary policy is the sole reason for the decline in inflation, then policy announcements should have become more consequential for the future direction of the economy. In my co-authored paper with Satadru Das and Jay Surti, Does Inflation Targeting Help Information Transmission? We evaluate this question empirically. We find that markets do not respond any differently to RBI announcements in the IT period. The bond markets used to react mildly to surprise announcements by RBI. They continue to do so in the latter period, but the magnitude of response has not changed. The stock markets remain docile in all periods.
Given that the stock market is reasonably deep in India, its non-response to RBI monetary policy announcements is surprising. Therefore, we check if Indian markets are immune to the announcements by the US Federal Reserve (Fed). And, the answer is no. Consequently, it is fair to conclude that the Indian markets do not draw growth-related information only in the case of RBI announcements. This bears out from the textual analysis of RBI policy statements as well. We find that RBI’s focus increased on inflation topics while on growth topics, it declined marginally (see graphic). Unsurprisingly, IT did not improve the information that RBI provides to the markets on growth. This result would appear unsurprising to those who have discussed the presence of fiscal dominance in India and the resulting insignificance of monetary policy on matters related to growth.
So, where does it leave us with this experiment? The results seem like a mixed bag. While inflation has been record-low since IT, RBI alone cannot be credited for it. At the same time, the markets do not seem to draw much information from RBI announcements. Our work raises questions on what central bank communication can achieve in an emerging market economy set up like India, which leaves the debate wide-open on IT.
The author is Assistant professor of Economics, ISB. Views are personal