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Business News/ Opinion / Cheers and challenges for Raghuram Rajan

Reserve Bank of India (RBI) governor Raghuram Rajan deserves cheers for sticking to his stand of making inflation targeting a part of India’s monetary policy framework at some point in the near future, albeit in a flexible form. While clarifying his position, Rajan made some observations, which should be analysed without adhering to any ideological framework.

Rajan’s three observations are: (1) RBI has not taken a view on the monetary policy framework recommended by the Urjit Patel Committee; (2) supporting inflation targeting does not mean that one is anti-growth; and (3) inflation target should be given by Parliament.

The first observation is just informative. The second suggests that there is a threshold rate of inflation (TRI) at the end of the medium term at which growth is optimized. The Urjit Patel Committee recommended that inflation rate based on consumer price index (CPI) change should be brought down symmetrically from 8% by January 2015 to 6% in January 2016 and 4% by January 2017. One tends to believe that 4% consumer price inflation forms the TRI for India.

The 8-6-4 formulation is different from what most Indian writings have shown as the threshold rate of inflation for India. They suggest that the threshold for India would be around 6% based on the changes in the wholesale price index (WPI). Given the difference between wholesale and consumer prices, a 6% inflation on WPI basis would translate to 7 to 8% inflation on CPI basis. What is surprising is that Patel Committee decided on a 4% rate at the end of the medium term without a clear-cut explanation—an omission that obfuscates an understanding of how the threshold has been arrived at in the Indian context. Was the Committee influenced by the views of the Sukhamoy Chakravarty Committee of 1985 without recognizing the changes in the pricing regimes since then?

It is well-known that most central banks, despite their dialectic rhetoric on inflation control, do not fully understand the cost of inflation. As such, they come out with what they believe is a tolerable rate of consumer inflation, which, by implication, is also the desirable rate. But they do not explain how this desirable rate of inflation is also the threshold rate.

There is also the analytical problem of knowing how an inflation path could be symmetrically laid down without assuming constancy in the central bank behaviour in the medium term. If such an assumption is made, then one would like to know the long-term implications of such behaviour.

Central banks tend to ensure that real interest rates are positive for the sake of allocative efficiency. The 4% of threshold inflation would act as a guidepost for central banks to act to secure positive real interest rates. But there is little evidence to suggest that the real interest rate maintained by central banks, while targeting inflation, optimizes growth as well. This is where one needs a sound theoretical frame that goes beyond empirical determination of threshold rate of inflation.

If RBI were to move toward flexible inflation targeting then it must have a clear view of what is the equilibrium real interest rate and the output gap—two variables that are not easily quantifiable. These critical variables along with the gap between the actual and target rates of inflation would, under the Taylor-type rule, help central banks to work out the nominal interest rate that is deemed to be the policy rate. The influence of central banks on the output gap and the equilibrium real interest rate is not strong enough.

Inflation targeting as a monetary policy approach had not been tested till 2008 in India and elsewhere. When financial imbalances grew in 2008 and became severe thereafter, most central banks had to focus on financial stability rather than on inflation targeting. Financial stability is the foundation on which central banking is based. With non-performing assets of banks on the rise at present in India and with uncertainties about the durability of the economic revival of industrialized economies, it is important that RBI makes it a point to provide the rationale for moving towards inflation targeting at this juncture. RBI should also provide an idea about the nature and quantum of its accountability for securing financial stability (even though one knows that it cannot be easily quantifiable) as much as it believes in its accountability for the formulation of monetary policy without being influenced by the government.

Rajan’s third observation about Parliament providing inflation target for RBI and not the finance ministry gives rise to many concerns. Should Parliament vote on a target of inflation by consensus or by a majority vote? Moreover, who should convey the inflation target to RBI? How do we ensure that the given target is growth optimizing? How should the RBI governor be made accountable for realizing the target? Should the RBI governor report to a person or a committee designated by Parliament with regard to achieving the inflation target? If Parliament does not come to any agreement on the inflation target, then what would be the RBI’s position with regard to the monetary policy framework?

For the sake of transparency and meaningful discussion, it is helpful if more light is thrown on the issues that the recommended monetary policy framework entails. Rajan needs to take up this challenge quickly and decisively.

A. Vasudevan is a former executive director of the Reserve Bank of India.

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Updated: 23 Apr 2014, 05:01 PM IST
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