The RBI’s move towards becoming an inflation targeting central bank, evident after the third quarter monetary policy review, is welcome. The policy review indicated the governor’s broad, implicit agreement with the Urjit Patel committee report on the framework of monetary policy. The report specified the nominal anchor of monetary policy — CPI inflation — and the policy instruments to be used over time. It also specified the target rate of inflation and a temporal roadmap for how to hit it.
The target itself is a bone of contention. Most economists agree that a certain amount of inflation is a necessary evil. In this case, however, some are worried that it is too low, that the structural constraints in the economy will not allow the RBI to achieve the target without significant monetary tightening. It has been pointed out that, given the average rate of food inflation over the past eight years (10 per cent), non-food inflation will have to be brought down to 2 per cent in order to achieve CPI inflation of 6 per cent (the report’s proposed target for 2016). But the optimal rate of inflation is an open question and a matter of judgement — there is no “right” answer. For instance, Olivier Blanchard et al (2010) wonder whether the additional flexibility that monetary policy has to deal with shocks at higher rates of inflation may mean a 4 per cent target is preferable to a 2 per cent one for advanced economies. Also, the concern that the non-food inflation required to support the RBI’s target is too “low” points towards the intertwining of monetary and fiscal policy. A monetary policy is only as good as the fiscal policy that supports it. In this instance, it’s up to the government to set the supply problems in agriculture right in order for food inflation to ease up.
Others worry that measurement problems with the CPI mean it should not be the metric of inflation used by the RBI. This, too, is not a principled stand against inflation targeting. The goal of using CPI to measure inflation itself is unexceptionable and brings the RBI in line with international best practice.
The report has touched off a larger debate about what a central bank’s role should be, particularly regarding the RBI’s mandate on growth. But there is no trade-off between inflation and growth in the long run. If anything, high and unstable inflation is a drag on growth. For commentators concerned about the constriction of the RBI’s discretion in setting monetary policy, game-theoretic models of central bank incentives may have the answer. In the absence of commitment, it can shown that there will be an “inflation bias” — that is, in spite of declaring an inflation target, the rate of inflation that finally results will be higher than the target, with no corresponding benefit for national output. However, if the central bank is able to credibly commit to its target, there is no inflation bias and, on average, the output is the same as when it is exercising discretion. What drives these results is the fact that central banks actually care about growth — this is precisely why we need commitment mechanisms in the first place.
But strict commitment has its drawbacks as well — it minimises the central bank’s ability to stabilise shocks. As does having blinders to everything but inflation. Clearly, inflation targeting came up short on account of the financial crisis. Central banks assumed that asset bubbles would make their radars beep as they found their way into measures of inflation, but this did not happen. Consequently, people have written obituaries for inflation targeting and wondered whether it should be replaced by nominal-GDP targeting, product-price targeting or a combination of mandates including financial stability and macroprudential regulation.
These concerns are probably why the report recommends flexible inflation targeting. The target rate of inflation has to be met over the business cycle, thereby making room for policy to target short-run growth shocks, among other things. Moreover, the report defines “failure” as not meeting the target for three successive quarters, upon which the monetary policy committee will only have to issue an explanatory public note. This will give the RBI the wiggle room it needs to focus attention on other more pressing things, if necessary. Compare this with strict inflation targeting in New Zealand, where the central bank governor can be dismissed for not meeting the inflation target.
Those writing off inflation targeting might cite the change in the Bank of England’s mandate in response to the financial crisis, which now includes financial stability alongside inflation targeting. But let’s not forget that as recently as January 2012, the US Federal Reserve formally announced an inflation target (2 per cent). The Bank of Japan followed suit in March 2013.
On this evidence, it would be premature to pronounce the death of inflation targeting. One reason inflation has been constant around a 2 per cent average for advanced economies in the recent past, in spite of recessions, is because inflation expectations are so firmly anchored, thanks to credible inflation targeting. This is also why the impact of monetary expansions has been benevolent. Firmly anchoring inflation expectations at a low level is one of the most important things for the Indian economy, and the Urjit Patel report shows the way.