Inflation Targeting and India

At the outset, I must apologetically admit that I too have succumbed to what is commonly known as blogger’s block. Honestly, I did not believe in its viciousness, but now I agree: It’s a real thing! Over the past few months, I have come across many interesting ideas to blog about but haven’t finished them, owing to a few distractions.

Okay, so this blog post is about Inflation Targeting and what’s in it for India. As the name suggests, it deals with (no prizes for guessing) – containing inflation to a specific target or number. Inflation is a big deal globally and especially so in India; the average Indian voter is quite aware of it. I don’t have statistics to back that claim but if you go to even remote villages, you’ll find most of the people complaining about price rise. Politicians canvass on this topic and even a couple of election results have been affected purely by high inflation. It is often used as a political weapon. This is obvious because poorer sections still dominate Indian electoral outcomes and in a sense it also means we are a strong democracy. To make things clear, let’s clarify a thing or two about inflation. (In a paragraph below I also explain some basics regarding inflation for the novice.)

1. Inflation is a year-on-year concept:

If the rate of inflation is 10% today, that means prices have increased (on average) by 10%  since “this same day last year”. It can be measured as month-on-month as well, but that definition and measure is generally never used.

2. Inflation is not unique:

There are many indices of inflation because of which there could be different inflation rates. For instance, taking into account only food gives you food inflation. Then there could be wholesale and consumer prices, which are obviously very different.

Why we need low inflation is pretty obvious: Rising prices directly affect our expenditure, and indirectly reduce our wages. Increasing inflation reduces the purchasing power of your salary. Higher the inflation, lesser of the goods you can buy that you used to. (That’s why economists like to distinguish wages as real wages and nominal wages. Simply put the real wage is when you adjust the actual wage that you earn – nominal wage – to account for inflation. You can do the same thing for other economic variables too – real GDP, real profits etc.) Inflation also affects investment. The argument is similar to the expenditure one, the result being that high inflation results in lower real returns. I’m sure many of us have gloated about our well-performing mutual fund investment; factor in inflation and you’ll sometimes see negative returns. Yes, you lost money. In real terms. Hehe.

Why we have to have ‘some’ amount of inflation on the other hand is not immediately clear. To explain that, I’m just going to say that prices are better determined by market forces – demand and supply – rather than by an exogenous agent. Taxes and subsidies are what distort prices and governments use these tools to achieve outcomes that markets are otherwise unable to achieve.

What is Inflation Targeting?

Coming to the point, inflation targeting (IT) is basically this: The central bank projects and announces a specified number or a ‘target’ for inflation and uses interest rates and other tools to nudge or reign in inflation towards that target. Remember that inflation and interest rates are inversely related. Simply put IT reigns in inflation expectations and investors’ expectations of future interest rate movements. At an institutional level, this helps improve the accountability of a central bank. Many countries (notably, New Zealand, UK, Canada, Israel, Australia, Brazil, Mexico, South Africa, among others) follow this approach to monetary policy. Some others like USA pursue what is termed as soft inflation targeting, i.e., attempting to commit to pursue inflation set to a range instead of a number.

The question then is: Should we have this framework in India or not? Well, we’re a democracy, so why don’t we go to vote on this? – It’s a simple yes/no question after all. Although simple, the arguments behind implementation and the consequences thereupon are quite intricate. Inflation has been high in India and if we need an RBI that is serious about containing inflation, maybe this is a step forward. Below I address the pros and cons, from studies in economic theory and empirics, of adopting IT below, and throw in my opinion as well, as usual.

Pros:

  • Improves the credibility of the central bank to sustain low levels of inflation
  • Impact of supply side shocks reduces on inflation

Cons:

  • Places little or no emphasis on other key goals such as financial stability
  • Does not respond to asset market bubbles and supply shocks

Let’s also have a look at what Indian economists have to say about Inflation Targeting.

  • Raghuram Rajan (RBI Governor) –  He has ruled out strict inflation targeting but is seen as a CPI inflation hawk to some extent, at least in the markets. Rajan has his eyes focused more towards the growth and reform picture that inflation, although a concern, seems to be only part of his plan. He is probably not India’s Paul Volcker, as was thought he’d be.
  • C. Rangarajan (Former RBI Governor) – His concern about strict inflation targeting comes from the fact that EMEs are still subject to supply shocks: that come from agriculture and more importantly international commodity prices, such as crude oil price.
  • D. Subbarao (Former RBI Governor) – His reservations against IT were driven by: (a) the RBI’s mandate, which consisted of many objectives, (b) supply-side inflation pressures, which IT cannot impact, (c) too many measures of inflation (CPI is not unique), and (d) monetary transmission in India, which is not proper as many kinds of administered interest rates like postal savings etc. exist.
  • Raghbendra Jha (Professor, ANU) – He basically says in this paper, that India is not ready for IT with widespread poverty still present and even if adopted will not be possible because of the ineffectiveness of the interest rate policy tool. Further, and most importantly, he also states that it although introducing IT definitely reduces the inflation rate, it doesn’t reduce it that substantially.
  • Ajay Shah (Professor, NIPFP) – He blames the RBI for not being able to combat inflation for the past many years. He also advocates for reform and a rethink on the RBI’s many objectives. The FSLRC recommendations are probably a step towards this direction (If interested, here’s a link to the FSLRC recommendations page). His opinions focus more on the bigger picture of institutional reform rather than policy debates, which are extremely relevant.

Inflation targeting and Emering markets

There are few preconditions that an economy must have for IT to be adoptable (see here). Among them, India might fail in satisfying a few, namely: low monetary policy credibility, vulnerability to sharp changes in capital flows, weak financial sector, excessive sensitivity to international investor sentiment. Not satisfying some of these conditions is somewhat like trying to live on Mars before checking whether there’s sufficient oxygen and habitable living conditions.

In my opinion, the RBI is already doing soft IT – the ‘softness’ being not specifying a target, but still closely monitoring the CPI. This might also be termed as de facto IT in the literature. The question now also arises of placing this de facto targeting into the RBI Act. Earlier the RBI was discredited by many economists for taking the WPI too seriously. While the WPI does serve its purpose, it is the CPI that reflects the actual ‘price burden’ on the common man. Further, thinking that the Indian ‘aam aadmi’ is one person is nearly fictional; its a very heterogenous concept. Indian consumption patters vary vastly across the country. In some areas rice is the staple diet, in others it is wheat-based bread. While dal (pulses) are treated as the main source for protein, many others opt for fish. Hence, even if CPI is adopted as the price target, my question is what weight will you give to these commodities? Will you account for population heterogeneity and composition? Because if you don’t, then adopting IT is not welfare improving collectively (not Pareto optimal). This is not the case in many smaller and less heterogenous countries, for instance France, where almost everybody will have almost the same diet consisting of bread (baguette), cheese and meat. Sorry for stereotyping, but its actually true. Lastly, India being a heavily oil dependent country, that makes us look abroad for fuel; the RBI might not be able to do full justice to an IT regime. Containing domestic prices might be feasible, but that’s a job only half done. There could be many other points on which IT is a good regime, I just blogged on what came to mind at first pass. Your comments could lead to an interesting discussion.

Cheers!

Unconventionally Yours.

PS: For the novice: –

Measures of Inflation in India: Consumer Price Index (CPI) and the Wholesale Price Index (WPI). There are four measures of CPI: CPI-UNME (Urban Non-Manual Employee), CPI-AL (Agricultural Labourer), CPI-RL (Rural Labourer) and CPI-IW (Industrial Worker).

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