For real interest rate to be positive, inflation rate should be 3-4% per annum
By A Vasudevan
RBI Governor Shaktikanta Das deserves praise for reviving the theme-based Report on Currency and Finance and chose a timely theme entitled ‘Reviewing the Monetary Policy (MP) Framework’ for presentation to the wider public. On its part, RBI has shown preference for not changing the inflation target as it exists, perhaps with the same band on either side of the target. The report, so well researched, brings to some of the old timers some recollections of what inflation target means. It also presents an opportunity to seek clarifications on a matter or two.
First, it is not explicitly clear as to why there is a need for inflation rate stability for the next five years? Is it by any chance the desired ‘threshold rate of inflation’ where growth would be optimised? Most studies on the threshold rate for India point to more than 4% per annum—often at 6-7%. An executive director of RBI speaking at the Delhi School of Economics some years ago suggested it could fall to 5%. It would be helpful if some light is thrown on the threshold rate in the future, assuming that such a rate is reckoned in the MP strategies. Again, should the band be symmetric? Why cannot we say 2 percentage points lower than and 1 percentage point higher than the 4%?
Second, why inflation targeting is qualified as ‘flexible’ (FIT)? Most Governors of RBI prefer discretion in policymaking, so long as discretion is credible. The flexibility in FIT might suggest that it inheres the discretionary component of the multiple indicator approach that was unveiled by Bimal Jalan as Governor. FIT became a part of the RBI Act essentially due to the pressure from Governor Raghuram Rajan. But Rajan is not the father of FIT: he caught on the signal from the then Prime Minister Manmohan Singh. Dr Singh, uncharacteristic to his personality, observed, while releasing the fourth volume of the history of RBI in August 2013, that he was not pleased with the conduct of MP under Governor Subba Rao.
He recounted his days as RBI Governor and stated that he wanted a clear focus of MP by appointing a committee with Prof Sukhamoy Chakravarty as the chairman. He further observed that he would ask Rajan to work out an approach to shifting out of the then MP framework to a new one. We are not so naïve as to believe that Dr Singh was not aware of Rajan’s sympathy with FIT as the author of financial sector reforms when Rajan was a consultant in the Planning Commission.
Immediately after assuming office, Rajan appointed a Working Group under the leadership not of an outsider but of his own deputy, Urjit Patel, and the action that raises questions of propriety. Patel’s recommendation for adoption of FIT came before Dr Singh vacated his office. Amazingly, Dr Singh has the distinction of being a driving force of two targeting frameworks for India. One wishes that this reality is well recognised in the monetary history of the country.
More fundamentally, it is not that RBI never had a view of tolerable inflation.
As a matter of fact, the government of India too showed concerns about inflation even though the literature often accuses fiscal policy of being so development biased that it is indifferent to inflation. Every plan document right from the 1950s mentioned about price stability and every Governor and deputy governors in charge of the economic department (in later years, MP Department) spoke about price stability. They could, however, be accused of being not explicit as to what price stability means. Checking with economists such as AK Dasgupta, PR Brahmananda and CN Vakil, who had been on the Panel of Economists of the 1950s, and with RBI Governors LK Jha, S Jagannathan, IG Patel and RN Malhotra by this author gave the feeling that inflation rate should be below the growth rate. For most of them, a 5-6% growth rate should be achievable, thereby indicating that for real interest rate to be positive, inflation rate should be 3-4% per annum.
The author is former executive director, RBI, and served as member of the Technical Advisory Committees on MP and RBI History