Central bank and inflation targeting

The change of guard at the Reserve Bank of India (RBI) this week is important for many reasons. The denial of extension by the government to Raghuram Rajan despite his willingness to continue points to the growing distrust between the central bank and the finance ministry. Since this is only the second instance after economic reforms when an incumbent governor has not got a term of five years, the lack of trust between the finance ministry and RBI is all the more telling, given the need to revive the economy. Further, the creation of the monetary policy committee (MPC) also implies a change in the way the policy is designed in the country.

While new governor Urjit Patel is expected to deal with the changed policy environment, he will also be looked upon to redefine the role of the central bank. The popular notion of the central bank and monetary policy as being the primary instrument of inflation targeting hasn’t proven to be relevant in the changing domestic and global environment. This is going to get further exacerbated with the changing financial architecture and the changing nature of inflation and price transmission.

Unfortunately, he will not have the luck that his predecessor had as far as inflation is concerned. Although Rajan gets credited for bringing inflation down, the fact is that monetary policy had very little to do with the decline in inflation since 2014.

There are three factors which helped keep inflation low in the last two years. The first was the sharp drop in petroleum prices after August 2014. But, along with the drop in petroleum prices, what also helped in keeping inflation low was the accompanying decline in primary commodity prices. Not only did metal and mineral prices decline sharply (around 40%) in the last two years, various agricultural commodities (cotton, guar, rubber, etc.) also witnessed a sharp fall in prices.

Secondly, the distress in rural areas that had started building up since November 2013 has continued until now. The drying up of demand in the last three years was seen in the decline in real wages in rural areas. There was also a decline in farm business income and a drop in construction and other non-farm activities which had maintained wage rate growth even during periods of drought. Another factor which contributed to the decline in rural demand was the cutback in rural spending, partly a result of the Fourteenth Finance Commission award and partly as a result of the government’s decision to cut back spending on rural programmes. Back-to-back droughts in the last two years only added to the misery of the rural population.

Thirdly, the continued recession in major markets outside India meant that exports fell throughout the last two years. The net result of weak domestic demand coupled with falling exports was a build-up of inventory and excess capacity in the manufacturing sector. While all these contributed to low inflation that persisted in the last two years, none of these was affected by the RBI’s monetary policy.

Nor was monetary policy successful in keeping retail inflation low. While retail inflation has come down as a result of the factors mentioned above, the real problem with inflation in India has been persistently high food inflation. While these have moderated a bit due to distress in the economy, they continue to be beyond acceptable limits. Some of the crops which have seen large fluctuations in prices such as onions, tomatoes and potatoes, along with the usual suspects such as pulses, continue to show high price volatility.

Most of the inflation in these food commodities has been due to structural problems of marketing, excessive speculation and flip-flop in government policy, with no role of monetary policy. This continues even today. The message is clear: neither was the high inflation a result of poor monetary policy nor is the decline in inflation a result of monetary policy. But on commodities which matter to the poor, especially food, the problem lies elsewhere.

The failure of monetary policy in controlling inflation in a developing country like India, where financial markets are weak and where inflation is largely structural, is obvious. But, even in the developed world, where the financial markets are well developed, central banks have struggled to use inflation targeting. There are now enough empirical studies on developing countries, including India, as well as on developed countries that suggest that inflation targeting may have outlived its role. The financial crash of 2008 is just a small reminder of the vulnerabilities of the financial sector to asset bubbles and speculative trading.

The challenge for the new governor is not just to deal with the issue of bridging the trust deficit between the government and RBI. It is also to redefine the role of RBI.

The Indian Financial Code (IFC) and the Monetary Policy Framework Agreement (MPFA), which continue to focus on inflation targeting as the central role of RBI despite evidence to the contrary, will remain the guiding frameworks in the coming days.

However, changing economic structure domestically as well as globally also suggests a need for focusing on stabilizing the financial market. While Rajan may not be credited with controlling inflation, he will surely be credited with cleaning up the toxic assets of banks.

The existence of crony capitalism and the corporate-bank nexus will require more than a cleaning up of the balance sheets of banks. But a bigger challenge will be to integrate the rural and informal economies with the financial economy.

In a country where a large majority is still unbanked and almost one-third of households are completely dependent on moneylenders, the real challenge is to make banking accessible to the common man, along with improving financial literacy.

Himanshu is an associate professor at Jawaharlal Nehru University and visiting fellow at Centre de Sciences Humaines, New Delhi.