Inflation targeting in democratic India

Much ink has been spilt on a recent remark by Reserve Bank of India (RBI) governer Urjit Patel. At the post-monetary policy press conference this month, he said the government of India had asked for a meeting with members of the monetary policy committee (MPC) and that they refused to travel to Delhi to meet with government officials. In a country where the so-called elite are always on the lookout for reasons to beat up the government with—and this government in particular—the RBI governor has given them a perfect story. David has slain Goliath.

Now, if only reality were so simple. Central banking independence is something of recent origin. Like all economic constructs and arrangements, its origins are political. Partially, it is a triumph of the interests of financial markets over the real economy, particularly over the working class. It is also anti-democratic in the sense that on certain matters, it seeks to place unelected technocrats—mostly academics unschooled in the real world of commerce, economic value addition and employment generation—ahead of the elected and accountable government. Many governments in the West agreed to go along with that arrangement because they had to be seen as responding to the high inflation-low growth decade of the 1970s.

Central banks had to find something to do with their new-found independence. In a conference organized by the Bank for International Settlements (BIS) in June 2010, Charles Goodhart of the London School of Economics said that central bankers were in search of an anchor for monetary policy in the 1980s and that the choice of an inflation rate target as the policy anchor in 1988 in New Zealand was by chance.

The choice of 2% as the target rate for inflation had no theoretical basis. Research by some academics and by the International Monetary Fund on the appropriate inflation levels for countries—levels that don’t have an adverse impact on economic output and employment—have always placed it at a much higher level than 2% and 4% for advanced nations and developing economies, respectively.

To be sure, India has had a history of high inflation. Inflation does extract an economic cost, especially if it is unanticipated, even partially. Moreover, in the five years ending March 2014, India’s annual inflation rate was in double digits. The currency became overvalued, the trade deficit spiralled out of control and the rupee plunged as the Federal Reserve threatened to turn less irresponsible with its monetary policy in 2013. So, there is a case for bringing down India’s inflation rate. The question, of course, is whether the central bank has anything to do with it.

Research by New Zealand—the first country to adopt inflation targeting in the modern era—has shown that New Zealanders were not influenced by their central bank’s anti-inflation monetary policy framework in the formation of their inflation expectations. They were more influenced by their last visit to the petrol pump and the supermarket. Of course, in the last three decades, ever since central banks in advanced nations adopted inflation targeting, there has been a secular decline in the realized inflation rates. But, correlation is not causality.

BIS—the banker to central banks—in its annual report for 2015-16, suggested that inflation was held in check by a combination of factors outside the control of central banks: “competitive forces and technology have eroded the pricing power of both producers and labour and have made the wage-price spirals of the past much less likely”.

The above discussion is meant to provide the context and backdrop for the two recommendations that I propose now. One, there is a case to revisit the symmetric range around the 4% inflation target for India. In fact, the lower bound should be 3% and the upper bound, 6%. It sends a signal that given India’s current state of economic growth, it makes sense to worry more about an inflation undershoot than an inflation overshoot.

Two, prior to the June policy meeting, the proposal made by the Union finance ministry to meet members of the RBI’s MPC created a needless flutter. This newspaper wrote an editorial disapproving of the proposal. The amendments made to the RBI Act facilitating the creation of MPC, etc., do provide for the government to share its views with the MPC in writing. It is time to make it somewhat more regular. The RBI Act has to be amended to provide for regular and more systematic government participation in MPC meetings. There should be a provision for two non-voting representatives of the government of India to attend MPC meetings and present their views on the economy and the preferences of the government to the MPC. Central banks in Japan and in Britain follow such a practice. In return, no other government representative, including the finance and commerce ministers, must opine publicly on the level of interest rates before an MPC meeting.

In an indirect reference to the demand for interest rate cuts to aid in capital formation, in its press statement following the MPC meeting, the RBI said that the government needed to do other things for interest rate cuts to be effective. The RBI is right. The government can help achieve price stability through reforms that improve the competitiveness of India’s product markets and labour and capital productivity. High real interest rates won’t be effective unless these happen.

V. Anantha Nageswaran is senior adjunct fellow (geoeconomics studies) at Gateway House: Indian Council on Global Relations, Mumbai. These are his personal views.

Read Anantha’s Mint columns at www.livemint.com/baretalk.

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