When it comes to tackling inflation, one cannot understate the overwhelming importance of pre-emptive policy, especially in Asian economies with varying degrees of price controls. Much of monetary policy debate, however, has focused on another issue—should policy be based on rules or the discretion of the central bank? The current “best practices” view is that it should be based upon a rule. Specifically, the consensus opinion has been for a direct inflation target rule. Well before becoming the Fed chairman, Ben Bernanke, along with Frederic Mishkin and Adam Posen, had argued for an inflation target in The Wall Street Journal in January 2000.
In India, Ajay Shah has lambasted the Reserve Bank of India (RBI) for not having an explicit inflation target (as many well-functioning central banks do). Instead, RBI semi-pegs the rupee and then abandons the peg when inflation gets out of hand. Policymakers are now firefighting and flip-flopping without an underlying conceptual framework, and without operational clarity.
(Illustration by: Malay Karmakar / Mint )
Against this backdrop, pursuing an inflation target seems to be both the logically correct and practical choice to follow. However, I shall argue that under current conditions it is simplistic and even dangerous to have a mechanical, explicit inflation rule. The whole debate of rules versus discretion has narrowed to one issue—Yes or No—on an inflation target. The more important matter—should policy be pre-emptive or reactive—has been neglected.
In principle, an inflation target rule makes sense. But choosing the right inflation target (and, more so, clearly defining the legislative procedures under which it is relaxed) can be very hard. Let us assess the practical difficulties with an inflation target in India. The Consumer Price Index (CPI), not the Wholesale Price Index (WPI) which is most looked at, is the conceptually correct measure for inflation targeting. Should not the CPI be promoted first before Parliament tries to fix 3% or 5% as the target number?
Switching to the CPI is not enough. The cost of living in India is very diverse. In rural areas, the cost of living revolves mainly around food, while in urban areas, housing, fuel and other costs matter a lot. Which CPI should the policymakers target—CPI (industrial workers) or CPI (agricultural labour)? What if the CPI for Industrial Workers is below target but for Agricultural Labour is way above target due to food inflation? Should a central bank in a poor country tighten policy in response to high food inflation when general inflation is within target, an issue that I first raised last August?
A whole set of issues also arises as to frequency and measurement— should we look at inflation year-over -year or, say, quarterly inflation, seasonally adjusted? The intra-year swings in inflation due to the base effect are huge. So, should a three- year average measure, which filters out noise from the base effect, be looked at, or is this statistic too slow and backward looking?
The practical difficulties of choosing an inflation measure, to target by rule, divert attention from whether policy should policy be reactive or pre-emptive. This fundamental dilemma of monetary policy was clearly laid out by Milton Friedman in December 1967. He first conceded that, as a target for the central bank, the price level as (or inflation rate in practice) is “clearly the most important in its own right”. However, he argued that a policy of direct inflation targeting (raise interest rates only when you actually see inflation in the “whites of the eyes” of the data, to use a common phrase) runs the risk of being too passive and reactive, and advocated a pre-emptive strategy.
Pre-emptive strategies can be based on intermediate targets (money, credit or nominal GNP growth) or information variables (equity and other asset prices, the yield curve) or simply tightening whenever real GDP growth is very rapid. The former 1980s US Fed chairman Paul Volcker, who conquered inflation, was against an explicit rule but pre-emptive in his approach.
There are sound reasons for being pre-emptive. It takes several years of overheating and real GDP growth above potential before nominal demand expansion shows up purely in higher inflation. This has to do with the nature of customer markets. Most product and labour markets are based on what Arthur Okun called the “invisible handshake”, as distinct from Adam Smith’s invisible hand. Reliability of supply, building consumer loyalty and considerations of costs and fairness play a big role in setting prices in customer markets, and for branded products, unlike in auction markets. In response to demand expansion, firms tend to increase output right away rather than raise prices. Hence, if growth suddenly rises without much inflation, a central bank should generally presume that the rise is not sustainable, rather than wait for actual inflation.
Compared with developed countries, in emerging economies there is another vital reason for a vigorously pre-emptive policy—retail price controls for oil and some other commodities. Even when there is no explicit price control, formal or informal approval of the relevant ministry is often required before raising prices for a range of commodities. As a result, inflation due to overheating was suppressed in India, China and elsewhere in recent years for a range of manufacturing items. We are now experiencing the pent- up inflation as controlled prices for various commodities are being raised sharply.
It is unfortunate that many well regarded economists naively broadcast the hype that India’s sustainable GDP growth is 8% or more. The lesson China and India should have learnt by now is that unless monetary policy is strongly pre-emptive, tightening later on is not enough.
Vivek Moorthy is a professor at IIM Bangalore. Comment at firstname.lastname@example.org