Much ink has been spilt in the past few months criticizing the interest rate-setting decisions of the Reserve Bank of India’s (RBI’s) monetary policy committee (MPC). The MPC was first criticized for leaving rates unchanged at its June meeting and then criticized again for lowering rates by only 25 basis points at its recently concluded August meeting (one basis point is one-hundredth of a percentage point). The complaints boil down to the claim that the MPC has consistently erred in overestimating inflation; therefore, it is argued, the monetary policy stance has been unduly hawkish, to the detriment of growth.
What the critics seem to be missing is that an inflation-targeting monetary policy regime, and inflation forecasting in particular, of necessity occurs in an environment of uncertainty and long and variable lags of the impact of policy on economic outcomes, all of which conspire to make monetary policy under such a regime an exercise in minimizing error, not in achieving a hypothetical optimal outcome.
Thus, the best that monetary policy can do is to try and keep inflation within a band of uncertainty—the notion that it can perfectly predict the path of future inflation and, therefore, can set the policy interest rate without the possibility of error is a fictional scenario set up by motivated critics, not a realistic benchmark against which to measure policy errors.
The reality is that the world over, in both advanced and emerging economies, and not just in the case of India’s MPC, economists have been consistently over-predicting inflation in recent years. Evidently, something systemic is at work here, not the putative machinations of an MPC deliberately overestimating inflation in order to keep interest rates higher than they should be.
In more technical terms, it would appear that the short-run Phillips curve—an empirical downward-sloping relationship between wage inflation and unemployment, or equivalently an upward-sloping relationship between price inflation and output—has become flatter, or that analysts are underestimating potential output (equivalently, over-estimating the Friedman-Phelps natural rate of unemployment), or that both are occurring.
Indeed, a recent research note by Citigroup chief economist Willem Buiter and associates finds merit in variants of both of these explanations. A larger-than- expected output gap—the difference between actual and potential output—results in lower-than-expected inflation. A flatter Phillips curve means that for any given output gap, inflation is lower than expected. Both sorts of errors have induced economists, Buiter argues, to consistently overestimate inflation in the past five years or so.
The reasons for such errors run the gamut from underestimating the productivity-enhancing effects of new technologies to increased economic openness to unusually long and persistent errors in household inflation expectations (or persistent errors in their measurement). In principle, these errors should disappear once forecasting models catch up with reality, but that process, too, occurs with a lag and not instantaneously.
In India, we have the additional fact that demonetization and its after-effects created their own uncertainty: Would the supply disruptions caused by the liquidity crunch in the immediate aftermath lead to higher-than-expected inflationary pressures, or, on the contrary, would temporary demand compression in the medium run put unexpected downward pressure on inflation? We know in hindsight that the latter effect has predominated, leading to lower-than-expected inflation, but this was not obvious in the early days after the demonetization decision.
The broader point is that a well-functioning MPC does not jump up and down in the face of minor and potentially transitory shocks, but attempts to smooth the changes in policy rates over the medium to longer run. This naturally imparts caution (or, if you prefer, inertia) to rate-setting behaviour, because this means it is better to err on the side of not cutting rates rather than cutting too much and then having to raise again in the near future (or the converse). By choosing caution in June and by cutting by 25 basis points in August, the MPC has allowed itself the margin to cut again if necessary or to hold the line if it appears that inflationary pressures are building up more than short-term forecasts had suggested.
What is more, the MPC itself has stressed that it is keeping an eye on incipient fiscal risks, arising from farm loan waivers in various states and the continuing recapitalization of banks. These provide an independent reason to be cautious in cutting rates prematurely. That is the “flexible" in inflation targeting: One looks out the front windshield rather than at the rear-view mirror in setting policy.
Finally, the critics fail to acknowledge that inflation targeting is a policy regime of recent provenance in India, as is the consumer price index (CPI) series which makes it possible. A certain amount of experimentation and learning by doing is bound to be expected and is as it should be. Rather than criticizing the understandable caution of India’s MPC in cutting rates, especially in a country with a political economy tilted towards higher inflation, we should be commending RBI governor Urjit Patel and the MPC for a journey well begun.
Vivek Dehejia is a Mint columnist and resident senior fellow at IDFC Institute, Mumbai. Read Vivek’s Mint columns at www.livemint.com/vivekdehejia