Home >opinion >online views >India needs an inflation-targeting RBI

Inflation has become the buzzword in recent times in India and has attained the same status as a political weapon in the hands of opposition parties as that of corruption to beat up the coalition in power. Relentless media coverage about inflation as a public enemy has only added to the confusion about the phenomenon being described, the causes attributed for its existence and the effectiveness of policy actions being taken to counter it.

It has also been pointed out that the lack of clarity in the Reserve Bank of India (RBI) on the monetary policy framework—which enunciates the goals, strategies and operational tactics for this framework—coupled with large fiscal deficits have contributed to the prevalence of high and persistent inflation in India in recent years. Before blaming RBI, in particular, for failing to control inflation, however, it is important to examine a few conceptual issues involved from first principles.

Inflation, while being a rather popular expression, is one of the most misused words in economics. Originally, inflation referred to a rise in the amount of paper currency in circulation relative to the precious metal that backed it. Later, the term referred to the amount of money in circulation relative to the money actually needed for trade. Today, however, people typically use the word to refer to a rise in some set of prices or even a single price with no necessary reference to money at all. An outcome of this evolution, unfortunately, is that the general public no longer distinguishes between these two very different types of price pressures.

The late Milton Friedman argued that inflation is always and everywhere a monetary phenomenon. Hence, it is controllable by a central bank. That said, the speed with which an inflationary monetary impulse filters through to all wages and prices depends on many factors. Most significantly, it depends on the degree of excess capacities in the economy and on the state of expectations of economic agents.

Inflation control is the clearest and most important mandate for any central bank. But they can do very little about relative prices as they do not have the instruments of supply-side management under their control. However, relative price rises do not fundamentally impair the ability of central banks to control aggregate inflation, as has been suggested in some policy circles in India in the recent past. This will complicate, though, the conduct of monetary policy in the short term, by highlighting the time lags and uncertainties involved in the monetary transmission mechanism. Herein lies an important lesson: in times of continued fiscal or supply shocks to prices, the extent, duration and certainty of effectiveness of monetary policy in controlling aggregate inflation could be different from those in normal times. This will imply that the implementation of a strict inflation target by monetary policy entails substantially higher costs (in terms of output losses) during certain times than others. In that sense, inflation generated in New Delhi cannot always be controlled from Mumbai without higher output losses.

This does not, however, mean that inflation control should not be an objective for monetary policy in times of supply shocks. Empirical evidence across the world has shown that the impact of supply shocks on aggregate inflation has been lower in those countries and times during which inflation targeting is pursued as (explicit or implicit) objective of the central bank. Inflation targeting regimes are expected to better control inflation expectations and thereby moderate the pass-through effects of supply shocks on to the aggregate inflation, and vice versa. The best way, therefore, to resolve this policy dilemma is flexible inflation targeting whereby inflation control is a declared objective of RBI, with the target being a band or range rather than a fixed number over a certain period of time.

A related question in this debate is whether RBI should target the consumer price index (CPI) or the wholesale price index (WPI) inflation or some other nominal anchor. The choice of the nominal anchor will have to be based on the size and stability of the correlation of it with the set of policy instruments on hand. It is likely that CPI inflation, which is significantly driven by the food and primary articles price inflation and more vulnerable to supply-side shocks, will not have a stable correlation with monetary policy instruments in short and medium time horizons. In that situation, one could set another nominal anchor, such as core inflation, that is better correlated with monetary policy instruments as the target variable.

The concerns about high and persistent CPI inflation can be addressed by the supply-side measures along with the introduction of CPI-inflation linked financial instruments that would act as inflation hedges.

In sum, anchoring generalized inflation expectations is the clearest and most important objective for any central bank and it could be achieved by a flexible inflation targeting framework along with the introduction of inflation-hedging financial products.

Gangadhar Darbha works for an investment bank in Mumbai. These are his personal views. Comments are welcome at theirview@livemint.com.

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