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).
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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 financial-capital flow cycle. Thus, in the period 2003 Q3 to 2008 Q3, monetary policy was too loose with respect to the domestic growth cycle because the central bank was constrained in its response to huge capital inflows and the appreciating rupee.
The low growth period 2008 Q4 to 2009 Q2 during the global financial crisis was also a period of huge capital outflows and sharp depreciation of the rupee. With a large stockpile of foreign currency reserves, monetary policy now focused on the domestic growth cycle. The period of high growth in 2009 Q3 to 2011 Q2 saw the return of capital flows and rupee appreciation, constraining monetary policy to shift its focus back to the external cycle. In the recent period, 2011 Q3 to 2013 Q4, despite the rupee coming under pressure on account of capital outflows and sharp depreciation, the focus of monetary policy shifted back to the domestic growth cycle.
What lessons can be derived from the experience of the last 10 years for India’s monetary policy framework going forward? First, the Taylor Rule is a single policy variable framework for responding to the domestic business cycle. However, cross-border capital flows are now increasingly driving business cycles, including asset prices, in emerging markets, exerting disinflationary or inflationary pressures through exchange-rate fluctuations. Since growth collapses just as the external cycle turns, central banks need to loosen monetary policy to stimulate growth but tighten it to prevent capital flight. They consequently find it impossible to use a single policy instrument, the short-term interest rate, to simultaneously target the domestic growth-inflation cycle and the external financial cycle. The latter is determined by the vagaries of monetary policies in reserve currency issuing countries and not by their own macroeconomic variables. According to the widely accepted Tinbergen Rule, a policy instrument can be effective only if it has a single objective. Developing countries therefore need to move beyond flexible inflation targeting to using a second policy instrument as part of a consistent framework to respond to the external financial cycle.
Second, while the financial regulatory structure may be robust enough to prevent loose domestic monetary policy spilling over into asset markets, the latter are nevertheless susceptible to spillovers from the monetary policies of advanced economies through capital flows. This warrants a suitable macro-prudential policy response. Third, and last, as long as there is fiscal dominance and a large weightage of food and fuel in the consumption basket, the credibility of any inflation-targeting monetary policy framework will remain at risk, as these are not easily amenable to monetary policy actions.
The writer is secretary, Prime Minister’s Economic Advisory Council. Views are personal