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Wednesday, May 18, 2022

How did inflation targeting really impact India?

Surjit S Bhalla writes: Inflation targeting in India was not responsible for the decline in inflation. It contributed to a decline in GDP growth because of excessively high real policy rates.

Written by Surjit S Bhalla |
Updated: March 20, 2021 8:56:00 am
(Illustration: C R Sasikumar)

Three decades after the start of the inflation targeting (IT) policy in New Zealand, and after its adoption by 33 countries, a question worth asking is whether it has succeeded in its primary objective of reducing inflation. The last two entrants to adopt the IT arsenal (an appropriate use of the warlike term is because its proponents do want to wage a war against the scourge of inflation) were Argentina and India in 2016.

The RBI has announced a formal review of the policy instrument now after six years of the Urjit Patel report (2014) on inflation and the use of inflation targeting. It was formally adopted in 2016. At the first meeting of the RBI Monetary Policy Committee in October 2016, it was also formally announced that the MPC considered a real repo rate of 1.25 per cent as the neutral real policy rate for the Indian economy.

By a neutral real policy rate, the RBI meant a policy rate consistent with growth at potential (for the Phillips curve enthusiasts, growth equal to that obtained at full employment). At the time of the announcement, GDP growth in India was averaging 7.9 per cent (second quarter of 2016) and inflation in August had come in at 5 per cent. Hence, the announcement of the repo rate at 6.25 per cent.

These are the monetary facts with which we can begin to assess whether IT in India has worked. The primary goal of IT was to contain inflation at around 4 per cent, within the allowable range of 2 to 6 per cent. In the main, the evaluation of IT must provide answers to the following two questions: Did inflation decline post the adoption of IT, and what was the role of IT in the decline in inflation? Equally important, was the adoption of IT associated with the policy of the highest real repo rates in India — ever — for almost three years 2017-2019? The answer is yes to the latter, but it also needs to be acknowledged that high real repo rates were the primary cause of the GDP growth decline in India from 8 per cent (pre-IT) to 5 per cent (post IT).

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All these questions, and more, are evaluated in the presentation by SBBL (Balasubramanian, Bhalla, Bhasin and Loungani) at ORF, March 18, 2021 (

As the IT policy is up for review, it has generated a healthy debate about its pros and cons. The heavy guns are broadly in the pro camp. An interesting feature of the Indian defence of IT is that very few of the protagonists mention the global context of inflation in which the decline in inflation has occurred, and those that incorporate global inflation trends do so in a cursory manner. An explicit goal of the SBBL paper is to evaluate IT in a global context, over the last 40 years, and for both the inflation targeters and the non-targeters, and separately for Advanced Economies (AEs) and Emerging Economies (EEs).

The table documents the historical pattern. Some surprising facts are the following. First, that annual median inflation in AEs has been consistently low, around 2.5 per cent for the last 30 years and a low of 1.5 per cent for the last five. So low that many central banks have official campaigns to raise the inflation rate. One conclusion might be that IT succeeded beyond anyone’s dreams. But attributing this decline in inflation to IT would be erroneous — and indeed is one of the central points of the SBBL paper.

Source: IMF WEO data Note: Real repo rate is defined as repo rate minus y-o-y CPI inflation

If anything is truly global it is inflation and price-taking by millions of producers in the world means that no one producer or one country can influence the price of any item or the general price level. So as Tina Turner might ask, what has IT got to do with the level of inflation?

Ah, but what about the price of oil? The price of oil is set by an oligopoly, and that surely affects general inflation, as we all inconveniently found out in the 1970s. But oil has ceased to be a factor in global inflation, at least post the mid-1980s. In this regard, it is instructive to look at the price of Brent oil. In December 1998, the average price of oil was $9.8 a barrel. In July 2008, the monthly average price of oil peaked at $ 133/barrel. Trough to peak the rise was 13 times over nine years. But what happened to AE inflation — nothing. More interesting is what happened to inflation among the non-targeters — median headline inflation declined — average AE inflation during 2005-2009 was 1.9 per cent, compared to the 2.7 per cent average in the 1990s

Closer to home, and very few of the IT protagonists will mention that, the lowest inflation in Indian history occurred during 1999-2005. After registering 13.3 per cent in 1998, inflation in India averaged only 3.9 per cent over the next seven years. The average median rate among EM targetters during 2000-04 was 4 per cent, and among the non-targetters 3.8 per cent.

But the theologians of inflation mention another important determinant of inflation — fiscal deficits. In 2003, India passed the FRBM act to control fiscal deficits and inflation. As I have mentioned in my columns, there is precious little evidence, either domestically or internationally, about fiscal deficits affecting inflation. Again, globalisation puts paid to that faith, as it did to the other fundamental of inflation — growth in money supply. Regarding the latter, in 1984, the US stopped publishing the weekly money supply growth numbers, data which prior to that date moved financial markets.

Let’s come back to fiscal deficits — surely the cause of inflation in India, notwithstanding global evidence to the contrary. For three consecutive years preceding the FRBM announcement, the consolidated Centre plus state deficits registered 10.9 per cent(in 2001), 10.4 and 10.9 per cent. For the seven-year 1999-2005 period, consolidated fiscal deficits averaged 9.4 per cent of GDP. Yet, we must acknowledge, and accept, that these years represented the golden period of Indian inflation — without FRBM and without IT.

At the time of the Patel report, inflation was raging and it is important to analyse why inflation catapulted to an annual average of 9.2 per cent between 2006 and 2013. This had nothing to do with the lack of inflation targeting or the enforcement of “low” fiscal deficits.

As the table makes abundantly clear, countries which have not adopted inflation targeting reveal lower inflation than those that did. There are also costs to inflation targeting in India. It led to higher real policy rates, in the mistaken belief that high policy rates affect the price of food, oil, or anything else. But high real rates affect economic growth, by affecting the cost of domestic capital in this ultra-competitive world. It is very likely not a coincidence that potential GDP growth, as acknowledged by RBI, was reached just before the MPC took over decision making in September 2016. Since then there was a steady increase in real policy rates, and a steady decline in GDP growth. It was only with a change in RBI leadership in late 2018 that real repo rates began to decline from historical highs. This move was a welcome departure from inflation targeting and a welcome one towards respecting the important role of monetary policy in affecting growth. It’s a move now acknowledged by most central banks in the advanced economies. Hence, we reach the conclusion, and the present reality of no country for inflation targeting.

This column first appeared in the print edition on March 20, 2021 under the title ‘No country for inflation targeting’. The writer is Executive Director IMF representing India, Sri Lanka, Bangladesh and Bhutan. The views expressed are those of the author and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

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