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By- Alok Sheel
India’s central bank needs to move beyond flexible inflation targeting
As the country debates what its monetary policy framework should be, it is perhaps a good time to assess the stance, determinants and outcomes of the extant framework over the last decade through the prism of a framework used by central banks the world over, the Taylor Rule. John B. Taylor has argued that his eponymous rule is, mutatis mutandis, relevant for developing country central banks. While there are a number of variations of the Taylor Rule, including those by Taylor himself, a commonly used formula is as follows: policy rate = last quarter inflation plus 0.5 (last quarter GDP minus potential GDP) plus 0.5 (last quarter inflation minus inflation target).
Two things are immediately apparent. First, monetary policy has been consistently very loose since 2003, both in periods of low and high growth. Second, since asset inflation seems to move in tandem with economic growth, this reflects optimism driven by sentiments surrounding growth prospects, rather than asset bubbles driven by loose monetary policy as in the US.
One can think of five possible reasons why monetary policy has been so loose over the past decade. First, the central bank may have been targeting alternative metrics of inflation, such as wholesale price or core inflation. Wholesale prices are not used by other central banks for the conduct of monetary policy. Core inflation is, but it is inappropriate for emerging markets because of its smaller weight in the consumption basket. Be that as it may, use of alternative metrics may qualify the extent to which monetary policy was loose but is unlikely to change the overall stance.
Second, the RBI may have followed the precedent set by advanced country central banks in easing aggressively in response to downturns without commensurate tightening in the upturn. Central bankers are, after all, part of the exclusive Basel club. The consequence was asset inflation in advanced economies and persistently high CPI in India. Third, the RBI may have given preference to growth over inflation, perhaps prodded by the treasury, either directly or indirectly through fiscal dominance. Since fiscal policy was lax, there was little that the central bank could have done but accommodate it to prevent even greater distortions.
Fourth, since the source of inflationary pressures in India was on the non-core side, which is less amenable to monetary policy action, periodic modest rate-hikes have been unable to tame inflation, making monetary policy look unusually loose in retrospect. As Paul Volcker showed in the US, monetary policy has to be used as a sledgehammer if it is to tame inflationary pressures emanating from the non-core side. The fifth explanation is that Indian monetary policy got trapped in the classic “impossible trinity” by trying to simultaneously target the domestic growth-inflation cycle and the external continued…