No Proof Required: Who is the real target?

No Proof Required: Who is the real target?

There is little evidence that inflation targeting helps reduce inflation — but it helps checkmate irresponsible politicians.

The RBI last hiked the repo rate by 25 bps to 8 per cent on January 28, 2014, on account of upside risks to inflation, to anchor inflation expectation and to contain second round effects.
There is no economic reason for targeting, but the experience of the last 10 years does indicate a political need. Can India afford another irresponsible politician or an adventurous political party? Possibly not.

In several previous articles, I have made the point that, at least in India, monetary policy (MP) has had precious little effect on inflation. From this, it does not follow that MP is inconsequential because, importantly, MP has had a large effect on growth. Real interest rates matter for capital formation and growth, and the lower such rates, ceteris paribus, the higher the investment and therefore growth. Now, before a smart graduate student objects and states that there will be no investment if land acquisition laws are enforced, or no investment if retrospective taxation is enforced, or no investment if projects don’t get cleared, or little investment when it is so difficult to do business in India… Of course, of course, of course. But for the umpteenth time, let me emphasise the importance of the Latin god, “ceteris paribus”, or a situation where all other things are equal. In laywoman’s terms, this is a situation where, for example, only interest rates are changed, and all other factors are isolated from causing any disruptions or confounding the shock to the system.

As discussed in several articles and the one on November 7 (‘A cut in time saves nine’, IE), the RBI has little empirical basis for not aggressively cutting rates. Anchoring of inflationary expectations, on which the RBI has spent considerable intellectual and policy energy, has been repeatedly revealed to be a false god. It is high time the RBI consulted the many organisations involved in political and economic polling to design their questionnaire on inflation expectations. I am happy to offer my services. But the RBI inflation expectations survey has to improve; at present, it is an embarrassment to the RBI and all those involved in statistical work in India.


There is one other (chinky?) defence that the RBI has to delay reducing policy rates. They can argue, as some rate-hawk experts are doing, that the RBI should wait until the implementation of the new monetary policy “inflation-targeting framework”. This framework would bestow all authority to the RBI for setting monetary policy, that is, no formal intervention of politicians will be possible. The logic of this recommendation to wait escapes me. It is like saying the government should not have prepared a July budget, since they were going to present a full budget in February.

In any case, the “inflation-targeting” model deserves a fuller examination. What evidence exists that inflation targeting works in reducing inflation in an economy? One might think that the RBI’s voluminous Urjit Patel’s “Report of the expert committee to revise and strengthen the monetary policy framework” might have some evidence regarding this important question. It does not. What it does have is a lot of discussion on the junk RBI inflation expectations survey (the very first chart shows inflation expectations in September 2013 of 13 per cent for September 2014 — the actual number was 6.5 per cent.). On page 21, the report does present a table for the year of adoption of inflation-targeting, the fiscal balanceon that date, and the fiscal balance in 2007.


There are two problems with this table. First, one would have expected documentation of where the fiscal balance was in 2013; second, this presentation takes for granted that there is a confirmed one-to-one link between fiscal imbalances and inflation. Peruse through any document of the RBI, or any research paper, which shows any statistical (not theoretical and not ideological) link between fiscal deficits and inflation in India. There is a reward waiting for you upon finding this evidence — however, if I were you, I would not waste my time.

But the nation needs to know the inflation-reduction record of targeting and non-targeting countries. And a fair amount of academic literature does exist on this subject. The table shows the inflation record of several economies grouped according to whether they formally adopted targeting versus those that did not. The former are further divided into Asian and non-Asian economies. The years have been grouped as follows. First, a base period before the advent of targeting, that is, the years 1991 to 1996. The second time-group is for the period of the Asian financial crisis, 1997 to 2000. The third for the pre-global crisis period of 2001 to 2006; and the fourth for the post-global crisis period of 2009 to 2013.

The following data are presented for each group of countries, and India and China separately. The CPI inflation level for the base period, and the average change in the inflation rate for different periods. In addition, the IMF WEO forecast of inflation in 2015 is reported.
A robust conclusion is that there is no evidence that inflation targeting works. The average reduction in inflation for the non-targeting countries between 1991-96 to 2009-13 is -2.5 per cent, and excluding India, -2.9 per cent. For the Asian targeters, the reduction is considerably less at -2.1 per cent. For the non-Asian targeters, the decline is somewhat greater at -3.6 per cent. India’s record in inflation decline, at least till 2006, is among the best. From near-double-digit levels in 1991-96, inflation averaged less than 5 per cent between 1997 and 2006. In summary, there does not appear to be any consistent evidence that targeting helps in the reduction of inflation. It may not hurt, but it does not help either.

However, CPI inflation in India did go through the roof and this explosion started sometime in 2006-07. The reason for this explosion has been well documented in this column — extremely irresponsible behaviour on the part of the Sonia Gandhi-led UPA to increase minimum support prices of foodgrains. Now that that story is over, inflation has come down to 6.5 per cent, and Oxus’s estimate is that the October CPI print will be much lower, and possibly as low as 5.5 per cent. So, in another year or so, inflation will be respectfully low in India, that is, less than 5 per cent. So what is the need for inflation targeting?

The IMF forecast for 2015 inflation makes for interesting reading. Substituting an inflation estimate of 5 per cent for India (rather than the exaggerated IMF estimate of 7.2), one obtains a near-identical estimate of inflation for Asia (3.1 per cent non-targeting and 3.2 per cent targeting), and a slightly lower estimate for non-Asia (2.5 per cent). Welcome to the world of inflation convergence.
There is no economic reason for targeting, but the experience of the last 10 years does indicate a political need. Can India afford another irresponsible politician (that is, Sonia Gandhi) or an adventurous political party? Possibly not, which is why I am not against the adoption of inflation targeting in India. But don’t fib me by saying we need targeting to reduce the inflation rate.

The writer is chairman of Oxus Investments, an emerging market advisory firm, and a senior advisor to Zyfin, a leading financial information company