Inflation targeting and credibility
Higher acceptable inflation will be an admission of the failure to deliver lower trend inflation
Now that the frenzied verbal volleyball over Reserve Bank of India (RBI) governor Raghuram Rajan’s decision to return to the world of ideas has subsided, it is constructive to calmly look at the future of the flexible inflation-targeting monetary framework. This was agreed to by the Narendra Modi government and RBI early last year. The benefits of this path-breaking reform continue to be under-appreciated or misconstrued.
The recent amendment to the RBI Act has already watered down the original monetary agreement somewhat. That agreement noted that the consumer price index (CPI) inflation target for financial year 2016-17 and all subsequent years shall be 4% with a +/-2% band. However, the recent amendment to the Act, which will supersede the agreement signed early last year and which also clears the way for the formation of a monetary policy committee (MPC), notes that the inflation target will be determined once every five years. The amendment doesn’t mention the inflation target range.
The flexible inflation-targeting monetary framework isn’t at risk, in my view. Abandoning this reform will be hugely embarrassing for the government after it agreed to it just early last year. Also, the target inflation range of 2-6%—outside of which the central bank will have to write to the government for the reasons for missing the inflation target and also suggest time-bound remedial actions—is already too wide.
However, the absence of the inflation target range in the amendment to the RBI Act and a categorical signal that the inflation target will be only for five years—not even one complete business cycle—suggest that the discipline of an inflation-targeting framework isn’t fully appreciated. Also, few in India realize that our current inflation target range of 2-6% is the widest among the main Asian inflation targeters. For example: Indonesia (3-5%), the Philippines (2-4%), Thailand (1-4%) and South Korea 2%.
Maybe the inflation target won’t be revised every five years. But the option exists now. This could offer room for some future government to live with higher inflation in anticipation of slightly better near-term growth, especially if it is worried about its political longevity. Politicians’ economic myopia will win, but the nation will lose if that approach leads to a boom-bust cycle. Indeed, the lessons from the last unprecedented—but unsustainable—growth upturn in 2003-08 have already been forgotten.
Embedding the inflation target range in the amendment to the RBI Act shouldn’t be confused with the debate over including the ceiling rate for the goods and services tax (GST) in the GST-enabling constitutional amendment. Tax rates can be revised, but if a sovereign plans to often revise medium-term inflation targets, it might as well avoid the flexible rule-based framework altogether.
Apart from the credibility of Rajan’s successor and the objectivity of the government-appointed MPC members, a key focus of investors will be revision—if any—in the current inflation target and/or its range. These will dictate whether the MPC will be a paper tiger or a reform taken seriously by the government.
For example, instead of targeting CPI inflation of 4% (which is the mid-point of the 2-6% range) from early 2018 onwards, could the government adopt, say, 5% as the target, with or without revising the range?
Before addressing the above, it is important to clarify that RBI isn’t aiming for inflation of 4% by early 2017, as some have mistakenly concluded. It has a forecast of 5% for early 2017 (i.e., within the target range), and a further 1 percentage point decline to 4% by early 2018.
Politicians and bureaucrats keen to justify more monetary easing might argue that the higher 5% inflation is acceptable as it is still within the 2-6% inflation target range. Consequently, according to this view, RBI should still be able to cut policy rates.
There are two problems with the above interpretation. First, the revised inflation of 5% falls in the upper half of the target range of 2-6%. Consequently, it is uncomfortably positioned and is hardly a conducive setting for policy rate cuts. Given the high volatility in India’s food inflation, frequent jumps in food prices could risk the upper end of the inflation target range being breached, resulting in a loss of the recently enhanced credibility.
Second, how will this about-turn be communicated? In its April 2016 biannual monetary policy report, RBI forecast CPI inflation at 5.1% year on year in the fourth quarter of fiscal 2017 and 4.2% in the fourth quarter of fiscal 2018. This compares with inflation of 5.8% year-on-year in June. Thus, a higher acceptable threshold for inflation via either revision to the inflation target or its range or RBI’s inflation forecast for early 2018 would be interpreted hugely negatively by fixed-income investors. They will see it as backtracking by the government.
Instead of further compromising the credibility of the monetary framework to facilitate lower interest rates, the government should step up its supply-side efforts to deliver low and stable inflation. This has the potential to offer a win-win combination of lower trend inflation and higher sustained economic growth.
The way to a significant and lasting downshift in interest rates, which in turn will boost growth, is a sustained decline in inflation, not forcing voters to live with higher-than-promised inflation. The 4% inflation target for early 2018 is ambitious but doable—that is the promising aspect of the Modi government.
However, the government’s institutional and supply-side reforms to achieve that inflation target have been disappointing. Revising the inflation target upwards to make up for that deficiency isn’t the right solution. In fact, such a revision would be the frankest admission of failure by the very government that agreed to it early last year.
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