The fall guy

Successful inflation targeting calls for more reform. Targeting Governor Raghuram Rajan is all too easy .

Written by Ila Patnaik | Published:May 28, 2016 12:05 am
raghuram rajan, rajan policies, RBI raghuram rajan, subramanian swamy, rajan, inflation, india inflation, business news, india news, latest news RBI Governor Raghuram Rajan.

Subramanian Swamy’s comments, though aimed at RBI governor Raghuram Rajan personally, have significance for the inflation targeting framework of the RBI. In the Budget Session of parliament, the RBI Act, 1934, was amended as part of the finance bill. Inflation targeting has now become law. Soon, the government will notify the level of inflation it wants the RBI to target in the next five years. I argue here that in the present circumstances the target inflation rate should be five per cent. Successful inflation targeting requires reforms that have not been implemented so far. Without a well-functioning bond market, end of financial repression, a competitive banking sector, an independent government debt manager and full understanding and commitment on part of government to low and stable inflation, inflation targeting will be a pipe dream.

In the last 25 years, the RBI has sometimes raised or lowered policy rates in order to control inflation either of its own account, or, since last year, as part of a formal agreement with the government. The Monetary Policy Framework Agreement (MPFA) signed in February 2015, for the first time, put in place an inflation target agreed upon by the RBI and government. As a first step towards making a commitment to low and stable inflation, this was a significant step. Many an expert committee had recommended that India should do what most other countries, including emerging economies, had done, and adopt inflation targeting as the objective of monetary policy. This framework was formalised with the signing of the MPFA.

In the past, the RBI had not systematically used either Consumer Price Index (CPI) or Wholesale Price Index (WPI) as the inflation target. However, the MPFA made CPI the mutually agreed target. Since then it was no longer Rajan’s unilateral decision to move from WPI to CPI, as Swamy believes. More so, last week through the amendment to the RBI Act, Parliament made CPI the target. But the main reason for Swamy’s unhappiness with the target appears to be the high interest rate regime under Rajan. This, no doubt, is hurting industry and employment.

What should the government do to help ensure that the objective of low and stable inflation as well as economic growth is achieved?

First, the government has the responsibility of notifying the inflation rate that it wishes to achieve. This rate is to be set every five years. The inflation target in the MPFA chosen by government and the RBI was 6 per cent by January 2016 and then 4 per cent for 2016-17 and thereafter (with a band of 2 per cent). This sudden jump down in the inflation rate appears at odds with the stated intent outlined in the Urjit Patel Committee report of setting a glide path to inflation. A glide path in the case of other countries such as Chile and the Czech Republic, cited in the report, was slower and smoother and a lowering of the target was done when the existing target was achieved and stabilised.

For India, a glide path would have meant that the economy reaches a stable 6 per cent, becomes comfortable with it, and then only the target is lowered to 5 per cent. If 4 per cent is the long-run stable target, as argued in the Urjit Patel Committee report, it would be unrealistic to jump straight to it.

Second, the government and the RBI should together review India’s first experience with formal inflation targeting. One of the well-known problems with monetary policy in the past one year has been the lack of transmission. It appears that given the lack of other reforms in the financial markets such as the creation of a well-functioning bond market, a competitive and market-oriented banking system, and a bond-currency-derivative nexus, monetary policy transmission does not happen easily. In this set-up, it is unlikely that the three-year path to a low and stable inflation envisaged in the MPFA can be achieved in a hurry.

It is important that we ask whether more reforms are needed before the target is lowered. Even if the government decides to lower the target, it should consider moving it from the present 6 per cent to 5 per cent. After transmission improves, inflation stabilises at 5 per cent and inflationary expectations come down, in the next setting of the inflation target five years later, the target could be brought down to the long-run target of 4 per cent.

Third, if the government wants to give the country low and stable inflation by adopting an independent monetary policy, it should clearly signal that it does not want the RBI to peg the exchange rate. One reason for the high interest rate regime has been the reluctance to ease liquidity after the shock to the rupee following the taper talk in May 2013. The unstated mandate of the RBI seems to be that it has to manage the exchange rate and prevent it from depreciation.

Fourth, the government needs to put an end to the foolish notion that the RBI can target WPI. The bulk of the items in WPI are tradables. Their prices are determined in international markets. WPI inflation closely follows the US producer price index based inflation rate. Inflation in WPI is determined by global commodity prices and not by domestic monetary policy. In other words, targeting WPI would be akin to targeting global commodity prices, something no central bank has control over. It is not surprising that no country ever tries to target it.

From the point of view of the domestic mandate, inflation measures based on CPI are the most common target for inflation-targeting countries. A couple of countries strip CPI of volatile food prices, but most central banks mainly use such a concept of “core inflation” in their internal models. CPI is the measure consumers relate to. WPI does not represent anyone’s basket, and at best, represents the price of inputs and outputs for producers. The choice of CPI is superior to the WPI because it measures the cost of living for consumers. Even though food is volatile, but because it matters to households, it is the rise in cost of living they care about. After all, governments adopt inflation targeting as the mandate they give to central banks because they want voters to have low and stable inflation. Incidentally, they also hand over this task to central banks so that if people get unhappy, such as with rate hikes, it is the central bank that gets blamed. Swamy seems to be doing pretty much that.

The writer is professor, National Institute of Public Finance and Policy, New Delhi

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  1. H
    Hemant Kumar
    May 28, 2016 at 7:50 am
    There are better economists than Raghuram Rajan in the country. In the past he has given political statements on lack of tolerance in India. He has tried to put ruling party in bad light and insulted the country by his remark "one e king in the land of blind" in respect of the performance of the Indian economy.
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    1. K
      Keerthana
      May 29, 2016 at 9:00 am
      There is sense in what Swamy is saying. Rajan was one in the Congress bandwagon calling India intolerant. But that aside, he has put forward a proposal to increase FDIs to 49%. This means reducing government control and a steady move towards privatization. He wants more foreign investment in PSBs . This would be a disaster. Ours is a pSB driven economy. Our banking sector is robust. It survived the 2008 crisis because we don't send to one rich capitalist but to 100 borrowers. Our risks are spread out. If we go the Rajan way India will end up having 100 Vijay mallyas!!! And 80% of domestic and Indian savings are parked in PSBs as they are secure. We are a nation that trusts PSBs with our funds. He wants the banking sector to go the American way. Suicidal move .
      Reply
      1. K
        K SHESHU
        May 28, 2016 at 10:41 am
        Targeting RBI and its governor by Swamy is to divert attention of people from targeting government. The best way of escape from people's wrath on inflation is to find a scapegoat -- RBI ..!
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          ak dev
          May 28, 2016 at 6:43 am
          No amount of secular praise will save Rajan. He must go now.
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          1. O
            Observer
            May 28, 2016 at 8:37 am
            Face the truth. Andho main kaana Raja. is so appropriate. Look within, and stop wearing Modi facades.
            Reply
            1. O
              Observer
              May 28, 2016 at 8:36 am
              RBI should target CPI along with the food inflation . Afterall in India, Food, Rent, healthcare, education, transportation, takes away 90% of the ordinary Indians earnings. Otherwise we are leaving out 1.2 billion Indians out of the reckoning.
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              1. A
                ashok s
                May 28, 2016 at 3:54 am
                Rajan should decrease rates is the only summarized version of full debate
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                1. A
                  ashok
                  May 28, 2016 at 8:45 am
                  But he is right. Currently our govt is very weak whether foreign policy (pak, china, nepal) or enlightened stuff. We need educated progressive leaders we had in congress. Country has grown tremendoulsy under congress taking our GDP to USd2trillion plus .
                  Reply
                  1. A
                    ashok
                    May 28, 2016 at 8:48 am
                    What the country needs is tolerant secular progressive mindset like we had for so many years during congress rule. Things have changed for the worse. India is no more india . Good forces should triumph evil ones
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                    1. A
                      ashok
                      May 28, 2016 at 7:10 am
                      Of course reforms are needed. All that has helped in the fight against inflation so far is the fortuitous fall in commodity prices.
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                      1. M
                        Mayank
                        May 28, 2016 at 5:03 am
                        Rajan is a puppet of west and working for their interest, even his family property are in US. He is US green card holder and surely return back to US, when he sacked
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                        1. N
                          Niladrinath Mohanty
                          May 28, 2016 at 4:02 am
                          For things to improve in India every citizen has to learn to sacrifice a little bit for the country. The Loka Sabha Speaker has not set a good example.
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                          1. M
                            madhu fan
                            May 28, 2016 at 12:26 pm
                            lol, you are funny
                            Reply
                            1. R
                              Ramesh Grover
                              May 28, 2016 at 3:30 am
                              It is a very well discussed analysis of ground situation , the impediments, and way out of it. Politicisation of such issues is fallacious and confounding.
                              Reply
                              1. S
                                sdsjkd
                                May 28, 2016 at 11:36 pm
                                we should respect his courage for speaking the truth
                                Reply
                                1. S
                                  SP
                                  May 28, 2016 at 8:03 am
                                  We should have a separate Food Price Index and that should be tracked. Other things that increase in India are cost of services, land etc. Most of the inflation in India now is due to internal issues. Even in case of Oil prices,, large component is tax.
                                  Reply
                                  1. S
                                    speakindia
                                    May 29, 2016 at 2:32 pm
                                    He wats people of india remain as they are for next century as well, dejected depressed, starved Serious And irritable.
                                    Reply
                                    1. S
                                      speakindia
                                      May 29, 2016 at 2:28 pm
                                      Looks like an NGO inspired vested interest penning an article as a journalist or guru of finance.
                                      Reply
                                      1. P
                                        Patel
                                        May 28, 2016 at 4:42 pm
                                        Maybe you need two types of inflation targeting one for food for which the government be accountable because they have the levers and the other for non food for which the rib be responsible in the early years the target's will be different but in time they could both merge when the agriculture sector would have the productive and storage capacity
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                                          Thomas George
                                          May 28, 2016 at 9:23 am
                                          But, he did not target the government. He was talking about the state of the economy. All the current troubles (including most NPAs) are a result of the indecision on project clearances and inability to help industries in trouble. When fuel prices went through the roof, the government did nothing to support airlines eventually leading to the demise of Kingfisher, and to the near demise of many others -- Jet was saved only by the Etihad deal.
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                                            Thomas George
                                            May 28, 2016 at 9:21 am
                                            He did not mean any harm by that. He merely said that the Indian growth and economy looks great only in comparison to the state of other economies. The implication was that we have a lot more to do, and that is right. There are significant parts of the Indian economy that is hurting -- Bank NPAs, many stuck projects etc. The funny thing is that these were issues created by the UPA government by their indecision in granting clearances. Why should the Government have taken offence is beyond my understanding.
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