When is a 4% inflation target really 4%?

The government’s fixing the inflation target at 4% +/-2 percentage points, as recommended by the Reserve Bank of India, signals that the political establishment too is committed to the fight against inflation. It seems to be, at first glance, a welcome if rather surprising affirmation of faith in Raghuram Rajan’s monetary policy stance.

Since his decision not to seek an extension, Rajan has refused to “go gentle into that good night”, instead making speech after speech spiritedly defending his decision to keep the policy rate high and arguing that it is necessary to combat deeply entrenched inflationary expectations. In a recent talk, he lamented, “Why is it that as we seem to be bringing inflation under control, public voices to abandon the fight are loud?” Indeed, there were some apprehensions the inflation target would be moved up to 5%. Those voices have been silenced and the doubts have now been laid to rest.

Or have they? The inflation range offers quite a bit of room for discretion. The government notification says, “The key advantage of a range around a target is that it allows MPC (Monetary Policy Committee) to recognise the short-run trade-offs between inflation and growth but enables it to pursue the inflation target in long run over the course of business cycle.” It says stipulating a range is necessary to take care of data limitations, fluctuations in agricultural production and short-term shocks. What about the 4% target then? According to the government notification, that is the rate “to which the monetary policy will return the economy over the medium term.” So, the 4% target rate is for the ‘long run’ and the ‘medium term’, terms you could interpret whichever way you like.

That’s not to say other inflation-targeting central banks don’t stipulate a range. The Philippines central bank has a target range of 4% +/-1 percentage point. The South African central bank has a range between 3% and 6%. Thailand’s is 3% +/- 1.5 percentage points. Quite a few of them say the target is to be achieved in the medium term. The arguments for having a range instead of a precise target are cogent and are a reiteration of those mentioned in the Urjit Patel report. Nevertheless, the fact remains that a dovish MPC headed by an uber-dovish governor may very well decide they can cut the repo rate even if inflation is just below 6%, on the grounds that it’s warranted at that particular stage of the business cycle and that it will eventually get to 4% over the longer term. As Federal Reserve chair Janet Yellen has proved in recent times, central bankers are adept at spinning the data whichever way suits them.

One reason why the RBI can afford to take a rather relaxed view of the target inflation rate is because they will be hauled up only if average inflation has been higher than 6% (or lower than 2%) for three consecutive quarters. In the wrong hands, that could mean inflation averaging 6% or slightly below for the better part of a year is perfectly fine and wouldn’t be called a monetary policy failure.

And then, of course, there’s what they call the ‘glide path’ or transition path towards the 4% rate. The agreement between the government and the RBI on the monetary policy framework, signed in February 2015, stipulated that “the target for financial year 2016-17 and all subsequent years shall be 4% with a band of +/-2%”. Many analysts initially believed that meant an inflation rate of 4% by March 2017. Rajan interpreted that to mean inflation should be 5% by the end of 2016-17 and 4% by January 2018. But that is what Rajan thinks. There is no particular reason why the next RBI governor will share that commitment. A dovish governor may prefer to quote St. Augustine: “O Lord, give me chastity and continence, but not now” and decide to shift the goal of 4% to a later date. In other words, it’s not clear when the 4% target rate will really be achieved.

But if the MPC decides to stick to the Rajan time-table of getting inflation down to 4% by January 2018, it has a tough task ahead of it. The chart shows the International Monetary Fund’s forecasts of consumer price inflation in India right up to 2021, the year till which the current target of 4% +/- 2 percentage points is valid. Note that it isn’t expected to come down anywhere near 4%. The Asian Development Bank forecasts Indian inflation at 5.8% in 2017. A recent note from UBS puts the inflation forecast for FY18 at 4.5%. A Citi report forecasts India’s consumer price inflation at 5% for 2018. In short, getting inflation down to 4% and keeping it there by 2018 is going to be tough. If they are serious about sticking to that target, where’s the scope for rate cuts?

Manas Chakravarty looks at trends and issues in the financial markets. Comments are welcome at capitalaccount@livemint.com