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.

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