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Business News/ Opinion / RBI set to enter the inflation targeting club
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RBI set to enter the inflation targeting club

It may be worth revisiting arguments made in favour of and against inflation targeting

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The week’s news has been dominated by the Reserve Bank of India (RBI). At a much watched monetary policy review, the RBI chose not to cut its benchmark policy rate despite calls from many (including the government) to do so. In not cutting rates, the central bank signalled that it is serious about bringing inflation under control in a sustainable way. Governor Raghuram Rajan said as much.

Beyond that headline, Rajan made another critical announcement linked to its inflation mandate—that the government has more or less accepted the RBI’s proposal to set a flexible target of 4% within a range of +-2%. The i’s have to be dotted and the t’s have to be crossed, Rajan said. But for all intents and purposes, it seems the RBI is set to enter the club of inflation targeting central banks.

As we move in that direction, it may be worth revisiting the various arguments made in favour of and against inflation targeting in India over the years. The debate goes back many years and many RBI governors. Until Rajan came along, most had actually taken a position against inflation targeting.

Most recently, Rajan’s predecessor, D. Subbarao, had argued that the central bank of an emerging economy like India cannot afford to exclusively focus on inflation, oblivious of the larger development context. In a speech in May 2011, at a meeting of the Central Bank Governance Group in Basel, Subbarao had noted that the RBI cannot escape the growth-inflation trade off in determining its monetary policy stance, and added that drivers of inflation in India often emanate from the supply side, which are tough to tackle from the monetary policy end. Among other arguments, Subbarao also made the point that a necessary condition for inflation targeting to work is to have an efficient monetary transmission system, which India is still struggling with.

Y.V. Reddy, who was governor between 2003 and 2008, has also not been a supporter of the idea. Speaking at a Bank of International Settlements (BIS) annual conference in 2008, Reddy had highlighted that two groups of commodities that carry a large weight in the consumption basket, namely food and fuel, are subject to supply side shocks, making it difficult to identify a core inflation that could be meaningfully targeted. Incidentally, Reddy’s 2008 opposition to inflation targeting had followed the report of a committee headed by Rajan, which had argued in favour of inflation targeting.

The Rajan-led committee on financial sector reforms had recommended that monetary policy in India should be reoriented towards a single objective and suggested that the single objective be “price stability". The committee went on to argue that a central bank focused on price stability can be the most effective in delivering good monetary and macro outcomes and that low and stable inflation has large macroeconomic benefits. Rajan has stuck to this argument even as governor.

Reddy, though, had made another candid point at a conference earlier this year, which alluded to the potential conflict that may arise if an irresponsible government (sometime down the road) follows inflationary fiscal and supply side policies and then leaves it to the RBI to tackle the inflationary aftermath. “What is the purpose of inflation-targeting? Is it to say that the government is not responsible and the RBI is responsible?" Reddy argued at a conference organized by the Centre for Advanced Financial Research and Learning, in August.

Go back another governor and Bimal Jalan, who held the post between 1997 and 2003, was also a sceptic of inflation targeting at the time. Delivering a C.D. Deshmukh lecture in 2000, Jalan had also alluded to the conflicts that can arise between a government and a central bank within an inflation targeting framework. “…what happens when things are not so good, or there is a conflict between the goal of preventing inflation from going up in future, say, 18 months later by half a percentage point over a low target of 2 or 2.5%, and a sharp downturn in industry here and now?" he had said. Jalan had added that a certain amount of flexibility in targets and balancing of conflicting objectives may be unavoidable, particularly when multiple choices are to be made and reconciled.

To be sure, the Urjit Patel committee, which has formed the basis of the RBI’s move towards inflation targeting, discussed each of these considerations in its January report. Yet, the report concluded that given the conditions facing India today, bringing down inflation must be accorded primacy and be made the nominal anchor for monetary policy. “This recommendation is intended to better ground inflation expectations by making clear that inflation is the RBI’s primary objective and that it expects to be held accountable for its performance in this regard," was the final word from the committee in this respect.

Now that the government has more or less accepted the RBI’s recommendations, the central bank has the tough task ahead of living up to this mandate. In the immediate term, the external environment has been favourable and has allowed the RBI to move smoothly along its suggested inflation glide path, which is taking it towards the 4% inflation target. However, the central bank would do well to remember that it won’t always be this easy. With the new system will come new challenges and conflicts.

Ira Dugal is assistant managing editor, Mint.

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Published: 04 Dec 2014, 05:10 PM IST
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