Inflation targeting, redux

Urjit Patel will take charge of Indian monetary affairs next week. The air is quite naturally buzzing with many questions about his attitude towards monetary policy. This is a good time to revisit these issues—and hopefully set some common misconceptions to rest.

First, few realize that the Reserve Bank of India (RBI) has committed itself to a regime of flexible inflation targeting. The word flexible is crucial here. Flexible inflation targeting means that a central bank will try to keep inflation close to its formal target while being sensitive to conditions in the real economy. That is what distinguishes flexible inflation targeting from pure inflation targeting. It is a subtle yet important distinction.

In the new monetary policy framework, persistently high inflation is deemed unacceptable because it harms economic growth over the medium term, as is well known. However, few seem to care that there is also an explicit recognition of a trade-off between inflation and growth in the short run, or what economists call the Philips Curve. So, the new monetary policy framework in India is actually more subtle than most people realize.

Here are two supporting facts. One, the monetary policy agreement signed between RBI and the government explicitly says that the task is “primarily to maintain price stability while keeping in mind the objective of growth”. It is not just about inflation. Two, the theoretical economic model underlying the new monetary policy framework has been very well explained in a box on page 12 of the Urjit Patel committee report. Real economic conditions enter the theoretical model in two ways—a New Keynesian Philips Curve as well as the output gap as a key element in a central bank response function (such as the Taylor Rule).

Second, once we accept that monetary policy will be flexible as long as inflation is within the range that has been given by the political system, the question is what Patel could do in the months ahead. Raghuram Rajan had to fight a blazing inflationary fire when he took charge three years ago. Inflation is now within the acceptable range—though the trend in recent months is ample cause for worry. A recent International Monetary Fund working paper by Sajjid Chinoy, Pankaj Kumar and Prachi Mishra shows that the recent disinflation is largely explained by Indian monetary policy and the deft handling of the food economy by the Narendra Modi government.

The amount of output that has to be sacrificed for a percentage point reduction in inflation is not a constant. There are minimal output losses when a central bank brings down inflation from very high levels. In fact, economic growth may actually pick up as prices stabilize. It is not so easy when inflation is within the target range. The additional output that needs to be given up for further gains against inflation is much higher. The mathematically minded will recognize a convex pattern here.

In other words, the trade-off between inflation and growth was relatively easier when inflation was being brought down in the first two stages—from 10% to 8% and then from 8% to 6%. The journey from 6% to 4% will be much more difficult. It could involve a much higher sacrifice ratio. That is why the nature of the monetary policy response could change in the coming months—not because there is a new governor, but because the underlying economic situation has changed. Monetary policy could be more flexible than widely assumed.

Third, Patel will now have to share the power to set interest rates with a new monetary policy committee (MPC). A lot depends on how he goes about the task. Most of the speculation right now is about who the three external members of the MPC will be. This has become a topic of a lot of idle chatter.

The more important question is how the rate-setting committee will operate. It is critical that the external members have access to all the internal data as well as empirical work done by RBI economists, so that everybody on the MPC has the same amount of information to take an informed call on interest rates. The old technical advisory committee (TAC) was constrained in this respect. It is also interesting to see whether the three RBI members of the MPC habitually vote as a block, in which case the external members will always be outvoted thanks to the veto that the governor has. How Patel nurtures this new institutional arrangement needs to be watched.

Patel is a reticent man—though he has actually given more speeches as deputy governor than the two speeches that have been mentioned in media reports after he was appointed governor. How he eventually runs Indian monetary policy will depend on the state of the underlying economy, but it is important to remember that the recent victories in the long battle against high inflation will give him space to be flexible. There is a reason it is called flexible inflation targeting.

Niranjan Rajadhyaksha is executive editor of Mint. Comments are welcome at cafeeconomics@livemint.com

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