RBI should not be pure inflation targeter,says Subbarao

The Reserve Bank cannot be,and indeed should not be,a pure inflation targeter,according to its governor D Subbarao....

The Reserve Bank cannot be,and indeed should not be,a pure inflation targeter,according to its governor D Subbarao. In an emerging economy like ours,it is not practical for the central bank to focus exclusively on inflation oblivious of the larger development context. The Reserve Bank needs to balance between growth,price stability and financial stability, the RBI governor said on Thursday. The answer to the old question,Should central banks be pure inflation targeters? has shifted from an increasingly confident yes to an increasingly qualified yes.

Post-crisis,the dominant view around the world is shaped by the new environment hypothesis which says that flexible inflation targeting,rather than pure inflation targeting,is more efficient. According to this hypothesis,if inflation is way off target,a central banks first call is to bring it within acceptable range,and if inflation is within the range,the central bank should focus on other objectives, he said while delivering the 10th C D Deshmukh Memorial Lecture. More often,the drivers of inflation in India emanate from the supply side. Food items have a weight of 46 to 70 per cent in various CPIs and are notoriously subject to supply shocks which are normally beyond the pale of monetary policy. This dilutes our potential effectiveness as inflation targeters, Subbarao said.

Which inflation index do we target? Our headline inflation index is the WPI and that does not,by definition,reflect the consumer price situation. Getting a single representative inflation rate for a large economy with 1.2 billion people,fragmented markets and diverse geography is a formidable challenge, he said. A necessary condition for inflation targeting to work is effective monetary transmission. Our monetary transmission mechanism is improving but is yet to reach robust standards. It remains impeded because of administered interest rates,the asymmetric contractual relationship between banks and their depositors,illiquid bond markets and large government borrowings. These impediments to monetary transmission diminish our effectiveness as inflation targeters, the governor said.

Large and volatile capital flows will continue to be an important feature of our external sector. Managing these flows will mean managing what has come to be called the impossible trinity 8211; balancing between the objectives of a fixed exchange rate,open capital account and independent monetary policy. Inflation targeting is clearly not possible in an impossible trinity situation, he said.

On whether financial stability should be an explicit mandate of the central banks,Subbarao said,pre-crisis,there was no answer; post-crisis,the answer is mostly yes.

Post-crisis,financial stability has come centre stage. One of the big lessons of this crisis is that financial stability can be jeopardized even in an environment of price stability and macroeconomic stability, he said. It is even possible to make a stronger argument,based on the experience of this crisis,that extended periods of price stability and macroeconomic stability may indeed blindside policy makers to financial instability brewing in the underbelly. These lessons from the crisis have triggered a vigorous debate on whether financial stability should be made an explicit mandate of central banks,he said.