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Business News/ Opinion / Columns/  Inflation target set for RBI but fiscal target breached
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Inflation target set for RBI but fiscal target breached

Government and RBI must hold up their end of the bargain for the new monetary policy framework to work effectively in the interest of the economy

Given that RBI under governor Raghuram Rajan has been pushing for a flexible inflation target, you would think this is good news for RBI. But read further down the speech and you get a reminder of why this move is a double-edged sword for RBI. Photo: BloombergPremium
Given that RBI under governor Raghuram Rajan has been pushing for a flexible inflation target, you would think this is good news for RBI. But read further down the speech and you get a reminder of why this move is a double-edged sword for RBI. Photo: Bloomberg

Budget 2015 may have been memorable for many reasons but the one that will find its way into the Reserve Bank of India’s (RBI’s) history books is the decision to establish RBI as an inflation targeting central bank.

A monetary policy framework agreement with RBI has been concluded and this framework clearly states the objective of keeping inflation below 6%, said the finance minister in his budget speech. No details were immediately provided by the government or RBI, except to say that the RBI Act would be amended this year. With this, RBI will move away from the multiple indicator approach to monetary policy that it has followed since the late 1990s and move towards making retail inflation the nominal anchor.

Given that RBI under governor Raghuram Rajan has been pushing for a flexible inflation target, you would think this is good news for RBI. But read further down the speech and you get a reminder of why this move towards inflation targeting is a double-edged sword for RBI.

While setting an inflation target, the government decided to go ahead and breach its own fiscal deficit targets set under the Fiscal Responsibility and Budget Management (FRBM) Act. Arguing that rushing into, or insisting on, a pre-set timetable for fiscal consolidation would not be pro-growth, the finance minister pushed back the objective of achieving a 3% fiscal deficit by a year to 2017-18.

This is in direct conflict with what the RBI committee headed by deputy governor Urjit Patel had recommended. The committee had said that the adoption of a flexible inflation target must be linked to certain pre-conditions, one of them being fiscal consolidation. The committee went on to state that achieving a 3% fiscal deficit by 2016-17 is “necessary and achievable."

Sure, one can argue that the government remains committed to fiscal consolidation in the medium term and that the target is only being pushed forward by a year. One can also highlight that the 6% inflation target spoken of by the finance minister is an easier ask than the 4% (+/-2%) medium-term target the RBI committee had recommended.

But if you look beyond the immediate, what this does is remind you that RBI will now be held responsible for maintaining inflation at a certain level irrespective of factors outside its control. The two most critical of these are fiscal policies followed by the government of the day and supply side factors which may lead to volatility in prices of certain components of retail inflation—like food and fuel.

You don’t have to go far back in history to remember the impact that imprudent government policies can have on inflation. The fiscal stimulus provided by the previous United Progressive Alliance government in the aftermath of the financial crisis, along with policies such as large increases in the minimum support prices for key crops, have been cited as among the key reasons that we saw a surge in inflation over the last few years. Consumer price inflation hit a record high of 11% in November 2013.

A research paper by economists Abhijit Sen Gupta and Rajeswari Sengupta, published by the Indira Gandhi Institute of Development Research (IGIDR) in June 2014, had found that shocks to fiscal deficit are an important factor in explaining the volatility of inflation in India.

“These shocks explain about 18% of the variation in inflation after three quarters. Thus, it is evident that expansionary fiscal policy by stimulating aggregate demand leads to a rise in price level in India. Hence, any success of the monetary policy in containing inflation would be crucially contingent on appropriate fiscal policy," the economists said in the research paper titled Is India ready for inflation-targeting?

The paper also noted that retail inflation in India is much more sensitive to supply-side pressures, including agriculture output and fuel prices, compared with demand-side pressures, and monetary policy has limited bearing on supply-side drivers.

Similar warnings about an inflation targeting framework have come from former governors of RBI over the years.

At a conference in 2014, Y.V. Reddy had alluded to the potential conflict that may arise due to fiscal and supply side policies followed by the government of the day. “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, according to a 15 January report in The Economic Times.

In 2011, D. Subbarao, too, had argued against inflation targeting, saying that drivers of inflation in India often emanate from the supply side, which are tough to tackle from the monetary policy end.

Way back in 2000, while delivering a C.D. Deshmukh lecture, Bimal Jalan, too, had cautioned that conflicts could arise between the goals of containing inflation 12-18 months down the road, and providing a boost to the economy in the near term.

These may seem like academic arguments now that a new monetary policy framework, which involves the setting of an inflation target, has been agreed upon. Still, the government and the central bank would do well to remember that each of them must hold up their end of the bargain for the new system to work effectively in the interest of the economy.

Ira Dugal is assistant managing editor, Mint.

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Published: 02 Mar 2015, 12:42 AM IST
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