India has unsurprisingly brushed-off any post-Brexit impact. Some of this is because emerging markets, themselves, have come under little stress so far. But a lot of this is because, in a matter of three years, India has gone from being the poster child of emerging market vulnerability to becoming the safe haven in that universe. Inflation has halved, the central government fiscal deficit has narrowed by a third, the current account deficit (CAD) has gone from 5 per cent of the GDP in 2013 to 1 per cent of GDP in 2016, and foreign exchange reserves are at a record high.
There are several proximate causes for the turnaround: Lower oil prices have helped across the board, the government’s bold FDI reforms have improved the quantum and quality of capital, and weak investment has narrowed the CAD. All are true at some level. But the bedrock of macroeconomic stability has been provided by sound fiscal and monetary policies post the taper tantrum, evidenced by the fact that the macros began to improve well before oil prices fell.
The question is how institutionalised are these policy frameworks. Can they survive regime changes? Reforms are also about ensuring that they are institutionalised such that future governments find it hard to reverse them for politically expedient reasons. Viewed from this lens, there has been dramatic progress on the new monetary policy framework. Just 30 months ago, monetary policy was still being run via a multiple indicator
Viewed from this lens, there has been dramatic progress on the new monetary policy framework. Just 30 months ago, monetary policy was still being run via a multiple indicator approach, creating uncertainty about the focus of policy. Inflation? Growth? Financial stability? Exchange rate? What combination thereof? Within inflation, was it CPI or WPI? Headline or core? Little wonder it was hard to anchor expectations.
But things moved rapidly from January 2014. The RBI implemented the Urjit Patel Committee Report — which recommended a decisive pivot to headline CPI targeting and a glide path to 8 per cent, 6 per cent and then 4 per cent with a band of +/- 2 per cent in the steady state. The new government was quickly on board with the FM arguing for a “modern monetary policy framework” in his maiden budget speech in July 2014. By February 2015, the ministry of finance and the RBI had entered into a monetary policy agreement which gave an unambiguous primacy to price stability, and spoke about targeting inflation at 4 per cent with a 2 per cent band on either side for “all subsequent years”. These may have been small changes in language. But they represented a huge leap in thinking. A public commitment to numerical targets was important to anchor expectations, create significant reputational risk to the RBI for missing targets, and create much-needed incentive-compatibility between fiscal and monetary policy.
All that was left was to formally incorporate this into the RBI Act, which the government did in the Finance Bill of 2016. The language in the Act on the objective of monetary policy is identical to the framework agreement giving primacy to price stability. The inflation target is clearly specified in terms of “Consumer Price Index Combined” — which refers to headline CPI — allaying concerns that the operational target could be changed to core CPI or WPI. Doing so would entail amending the RBI Act. Finally, the Act lays out the formation, structure and processes of a six-member monetary policy committee (MPC) in impressive detail. This allows for a variety of views, and continuity in decision-making across governors.
Perhaps the only quibble is that the broad inflation target range (2-6 per cent) is not in the RBI Act. Instead, the Act mandates that the central government, in consultation with the RBI, determine the inflation target every five years and notify it accordingly. A notification has not been issued thus far and, when it comes, it will supersede the target in the monetary policy agreement. In theory, the government can change the inflation target from what it had agreed to last year. In practice, this is very unlikely. Authorities will recognise that the essence of inflation targeting is about consistent application to anchor inflation expectations. It’s hard to anchor expectations if we have a moving target. So we would be very surprised if the government having just signed on to a target would reverse that.
This raises the larger question of whether at least the upper (6 per cent) and lower bounds (2 per cent) of the target range should have been hard-coded into the RBI Act? True, very few countries hard-code the numerical target into the Act, but that’s also because they have much tighter bands that constrain policy. In India’s case, the range is so wide that it would not necessarily constrain responding to shocks. In response, the RBI could always operate at a different point in the band, commensurate with the shock. Monetary policy would have enough room to manoeuvre. But hard-coding the upper end (6 per cent) into the RBI Act would have given more confidence to economic agents that inflation would not stay above 6 per cent on a sustained basis, like it did during 2008-14. In the “rules versus discretion” debate, emerging markets are replete with examples of unbounded discretion leading to time-inconsistency problems. Hard-coding the boundaries into the Act would have created bounded-discretion.
In the “rules versus discretion” debate, emerging markets are replete with examples of unbounded discretion leading to time-inconsistency problems. Hard-coding the boundaries into the Act would have created bounded-discretion.
The sovereign could, of course, change the Act at any time. But it would require legislative change with greater reputational consequences. The bar for reversing course would be higher versus the current scenario where the default is the government-of-the-day must pick a target every five years, leading to concerns that targets could be opportunistically tinkered with, down the line.One could, of course, ask why any sovereign would want to target inflation higher than 6
One could, of course, ask why any sovereign would want to target inflation higher than 6 per cent given the adverse political economy of high inflation? In India’s case, though, the current calendar of choosing the inflation target every five years will not run co-terminus with the political cycle, assuming five-year terms for all future governments. Instead the choice of target will fall in the middle of each future government’s tenure, raising concerns about time-inconsistency.
In just two years, India has seen a remarkable transformation and institutionalisation of its monetary policy framework, for which the government and the RBI deserve credit. The sooner the government notifies the inflation target (with the hope that the goalpost is not changed) the faster the speculation will end, and we can appreciate just how much has been accomplished.