Monday, Dec 22, 2014

With an eye on inflation

After 2000, a number of emerging economies adopted inflation-targeting frameworks and have enjoyed its fruits. After 2000, a number of emerging economies adopted inflation-targeting frameworks and have enjoyed its fruits.
Written by Ila Patnaik | Posted: February 14, 2014 2:38 am | Updated: February 14, 2014 9:24 am

Flexible inflation targeting is the best way to dent price rise.

India is the only large emerging market (EM) that doesn’t currently have a monetary policy framework. Other than China, which targets the exchange rate, all large EMs target inflation. This is one of the main reasons why India saw a rise in inflation after the global financial crisis, while other EMs experienced a downward pressure on prices. It is clear to students of monetary economics that an inflation-targeting framework is the way forward for India, which is opening up its capital account and moving towards a flexible exchange rate regime.

India has chosen these two corners of the trinity — and this allows it to have an independent monetary policy. The lack of a monetary policy framework is a recipe for high inflation, low growth and highly volatile business cycles. The Urjit Patel report to revise and strengthen the monetary policy framework has recommended that the RBI adopt flexible inflation targeting.

What are the main elements of inflation targeting? First, a monetary policy framework requires a defined nominal anchor. There are many factors that determine the relative price of any two goods, while the nominal anchor determines the general level of prices. So, for example, if there are only two goods in an economy, and one costs double the other, what determines whether the prices are Rs 10 and 20 or Rs 100 and 200? When economies started using paper money, it became possible to create an unlimited amount of money. But this could cause these prices to rise to Rs 1,000 and 2,000 or any other such combination.

When paper money was anchored to gold or silver, or, in some cases, to the sterling or dollar, this used to determine the general level of prices. However, when these systems ran into trouble, countries chose a general price level as the anchor, with some allowance for changes in relative prices. A small amount of growth in the general price level allows for smooth changes in relative prices. Thus, the price level and a small, specified increase in it became the nominal anchor. This was the inflation target.

Such an anchor incentivises households to save. It allows businesses to plan, knowing how their cost structure will evolve over the years. After 1990, inflation targeting was adopted by 34 countries. The OECD countries were among the first to adopt it and, after 2000, a number of emerging economies such as Brazil, Chile, Colombia, South Africa, Thailand, South Korea, Mexico, Peru, the Philippines, Indonesia, Turkey and many east European countries followed suit.

More recently, after the global financial crisis, even developing countries started adopting this framework. After 2008, we have seen countries like Georgia, Moldova, Albania, Botswana and, in 2011, Uganda adopt inflation targeting. The fruits of the continued…

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