The currency question

As the tenure of Reserve Bank of India (RBI) governor Raghuram Rajan draws to a close, appreciations and encomia have been pouring in. An editorial in this newspaper argued that, if one had to sift all of Rajan’s accomplishments, the adoption of inflation targeting as India’s new monetary policy paradigm “is undoubtedly Rajan’s most defining contribution to policymaking as governor”. This is most certainly true—whether one applauds the move or is critical of it, it represents an important structural shift in one of the two pillars of conventional macroeconomic policy (the other, of course, being fiscal policy).

Much ink has been spilt, including, it must be confessed, by your columnist, on assessing the pros and cons of an inflation-targeting monetary policy rule, both in general, and for India, in particular. To summarize, proponents of India’s adoption of inflation targeting point to the fact that this is the gold standard of contemporary monetary policy science and practice and that a version of it is used by every major advanced economy central bank. It thus follows naturally, for the supporters, that it makes sense for India, too, to have adopted this system.

Critics of India’s adoption of inflation targeting point out that the system itself revealed serious flaws in the build-up to, and the aftermath of, the global financial crisis of 2008 and on. In particular, as is now widely acknowledged, a singular fixation on inflation in the consumer price index (CPI) by central banks such as the US Federal Reserve System blinded central bankers to the dangers of asset price inflation and, indeed, the formation of perilous and potentially destabilizing bubbles in the prices of various assets, including, of course, in the sub-prime mortgage housing market in the US and property markets elsewhere.

We know how badly that movie ended, and the world is still living with the consequences in its interminable sequels. Thus, even in the US and elsewhere in the advanced economies, and among regulatory agencies and global financial institutions, serious and credible economists, analysts and policymakers are raising legitimate questions about whether inflation targeting ought to be tempered to allow central bankers to use conventional monetary policy tools (in particular, the policy interest rate) to prick incipient asset prices bubbles prophylactically.

Defenders of the status quo will respond, with some plausibility, that if one does not like inflation targeting, then what would you propose replacing it with? Given that a central bank is committed to a flexible exchange rate, then some nominal anchor must be picked, and a policy rule created which maps the policy interest rate into a desired outcome.

Indeed, before inflation targeting was hit upon, the previous benchmark approach, later largely discarded, was monetary targeting—an approach proposed by Nobel economist Milton Friedman—whereby the central bank directly targets a chosen monetary aggregate, with inflation being determined for a given velocity of circulation.

Defenders will also argue, with some justice, that monetary policy is a blunt tool in trying to combat asset price bubbles, and that so-called “macro-prudential” policies ought to be used instead. This is the source of a lively and as yet unresolved academic and policy debate with which readers of this newspaper will likely be familiar.

In a word, then, while the mainstream consensus in the economics profession favours inflation targeting—assuming as a given that one is committed to a system of flexible exchange rates—that is now marked with an asterisk, for the reasons I have suggested.

It must be added that this leaves aside the larger debate on whether a global system (or rather “non-system”, as Nobel economist Robert Mundell has rightly dubbed it) of central banks, each pursuing its own monetary policy rule and tied together by flexible exchange rates, makes sense to begin with.

The alternative, as I have discussed in this space on several occasions, would be some form of Bretton Woods Mark II, which recreates a global unit of account, much as the original Bretton Woods system was anchored by the US dollar fixing the price of gold at $35 an ounce and all other economies fixing to the dollar.

The narrower question for India, which obviously is not in a position to shape the global monetary order to its will, would be whether, in the current global non-system, inflation targeting by the RBI is the best amongst available choices. Recall that, at least in theory, a classical inflation-targeting rule disregards the path of the nominal exchange rate, except insofar as it feeds into anticipated future inflation.

Thus, at least in theory, an inflation-targeting central bank has no intrinsic interest in stabilizing the exchange rate or even in dampening its volatility (unless these have induced effects on anticipated future inflation).

At the moment, this may appear to be an academic question: we have, after all, already committed to inflation targeting, and it is a little late to be considering alternatives. But then, since adopting the new regime, we have not as yet witnessed a major bout of exchange rate instability, of the sort that characterized the taper talk crisis of May 2013, before the new system (and the present governor) were in place.

Every fortnight, In the Margins explores the intersection of economics, politics and public policy to help cast light on current affairs.

Comments are welcome at views@livemint.com. To read Vivek Dehejia’s previous columns, go to www.livemint.com/vivekdehejia