Monetary policy analysis in the new Keynesian framework has received considerable attention in recent times. The New Keynesian Phillips Curve (NKPC), one of the important blocks of the New Keynesian framework, has become a dominant tool to model inflation dynamics among central bankers. Unlike the traditional Phillips curve where inflation expectations are adaptive in nature, the NKPC is based on forward looking (rational) expectations. It relates current inflation to the expected future inflation and the output gap.

Many central banks around the world have adopted an inflation targeting framework, also called “flexible inflation targeting" (FIT), wherein issues pertaining to output growth are also accommodated with the primary objective of price stability. For an inflation-targeting central bank, understanding the dynamics of inflation is a prerequisite to developing a perspective on what type of monetary policy is required to achieve the inflation target on a sustainable basis. Since inflation dynamics can be modelled using the Phillips curve, the nature of the Phillips curve provides key inputs in policy formulation. It is a well-known fact that the success of the monetary policy depends on how well it manages the expectations of economic agents. Especially, for inflation-targeting monetary policy, understanding the nature of inflation expectations is of paramount importance. If the inflation process is highly persistent due to backward-looking inflation expectations, the inflation-output trade-off becomes sharper, resulting in a painful disinflation process. Conversely, if the inflation process is forward looking, disinflation can be effected without any loss in the output. The credibility of monetary policy plays a crucial role in this context.

A highly credible central bank can anchor the medium to long-term inflation expectations around the target and hence disinflation occurs smoothly without much disruption to the output. Also, if the inflation expectations are firmly anchored, any temporary shocks to inflation would not persist for long, thereby making the task of monetary policy easy. Importantly, the forward-looking nature of the NKPC makes it an ideal candidate to model inflation in the presence of forward-looking inflation expectations. The NKPC therefore has important implications for inflation-targeting monetary policy.

Besides the nature of inflation expectations, the slope of the Phillips curve also has important implications for monetary policy. The slope of the Phillips curve measures the responsiveness of inflation to fluctuations in the output gap. While a steep slope implies that inflation is highly sensitive to cyclical fluctuations, a flat Phillips curve signifies the opposite. The International Monetary Fund’s World Economic Outlook (April 2013) had a very interesting chapter titled “The Dog That Didn’t bark: Has Inflation Been Muzzled Or Was It Just sleeping?" The chapter explains how inflation in the advanced countries did not fall, even after large increases in unemployment during the great recession that ensued from the 2008 financial crisis. Two very logical explanations were put forth to explain this puzzle: First, it was found that the relation between inflation and the economic slack has weakened over the last few years, implying a flatter Phillips curve. Second, credible central banks may have firmly anchored inflation expectations and contributed to keeping inflation more stable.

The combination of highly persistent inflation and a flatter Phillips curve throws up difficult challenges for monetary policy. If the inflation process is dominated by supply shocks which are persistent, the monetary policy needs to be tightened over a substantial period to stabilize inflation. This ends up hurting output growth. The flatter Phillips curve further aggravates the problem as a large fall in output is required to reduce inflation even by a tiny proportion. If inflation occurs only because of demand shocks represented by fluctuation in output gap, it simplifies the task for monetary policy as stabilizing inflation is equivalent to stabilizing the output gap, as the output gap and inflation move in the same direction. This scenario is called a “divine coincidence" in the language of economists. However, inflation generated through cost-push shocks poses a dilemma for monetary policy as the output gap and inflation move in opposite directions and stabilizing inflation is not equivalent to stabilizing the output gap.

The Reserve Bank of India (RBI) has adopted the FIT framework with consumer price index inflation as the nominal anchor. The primary objective of monetary policy is to achieve the inflation target over the medium-run with some flexibility to address growth concerns in the short-run. The given flexibility is important to address the high-inflation-low-growth puzzle confronted by the Indian economy recently. Even though inflation in India is susceptible to different supply shocks, firmly anchored medium- to long- run inflation expectations may generate the scope for monetary policy to stimulate growth in the short-run by allowing inflation to deviate from the target. In short, the slope of the Phillips curve and the nature of inflation expectations are important ingredients in the process of policy formulations under the FIT framework. The overall success of inflation-targeting framework depends on how credible the central bank is and how well the inflation expectations are being anchored. The RBI needs to do exactly that.

Bhavesh Salunkhe and Anuradha Patnaik are, respectively, senior research fellow and assistant professor, at Mumbai School of Economics and Public Policy (Autonomous), University of Mumbai.

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