BackInflation targeting and the evolution of monetary policy
There is no credible alternative to inflation targeting in the world of central banking today
Premium
Newspaper headlines have been dominated in the past week by commentary, most of it negative, on the latest draft of the Indian Financial Code (IFC), and, most particularly, the proposed monetary policy committee (MPC). Mint carried a leader sharply critical of the proposal, echoing the editorial stance of most major financial newspapers. For the record, economist Rajeswari Sengupta and I have written, also in Mint, in favour of the IFC and the MPC. There is also a spirited defence of the IFC by one of its intellectual architects, economist Ajay Shah.
Unfortunately, the single-minded focus of much commentary on the MPC—the most controversial feature being that it will have a majority of its members appointed by the finance ministry, rather than the Reserve Bank of India (RBI)—detracts from a larger debate on the overall merits of the IFC. What is more, it is impossible to debate sensibly how the MPC will function without delving more deeply into the Monetary Policy Framework Agreement (MPFA), agreed upon in February between the finance ministry and RBI. This fulfils a promise made by finance minister Arun Jaitley in the Union budget 2013, in which he promised a “modern monetary policy framework to meet the challenge of an increasingly complex economy".
In simple terms, the MPFA mandates that RBI will target inflation in the consumer price index (CPI) at 4%, with a tolerance band of 2% around the target. If the IFC draft is accepted, it will be the MPC that will be charged with implementing the target. In thus creating an explicit inflation-targeting policy mandate for the central bank, entrusted to an MPC, India will join the ranks of modern central banks.
But when and how did inflation targeting become the norm for central banking? To understand this, we need to look back at history. For centuries, indeed millennia, currencies were tied to precious metals—often gold or silver, or some combination of the two (the last of these being known as “bimetallism").
In the period before the outbreak of World War I, most currencies were based on the gold standard—so that each unit of a national currency was worth, and was redeemable for, a certain quantity of gold. This also meant automatically that national currencies were linked together through a system of fixed exchange rates; the exchange rate between any pair of currencies would just be the ratio of the gold content of those currencies. Monetary policy simply consisted in ensuring that the stock of money in circulation was adjusted in proportion to the stock of gold that the central bank held, with balance of payments disequilibria being settled by gold transfers between deficit and surplus nations.
This system, which brought the world an era of monetary stability that coincided with great prosperity, at least in the advanced economies, broke down with the outbreak of World War I. After various failed attempts to recreate the gold standard during the interwar years, the years after World War II were dominated by the Bretton Woods system, which, along with creating the World Bank and International Monetary Fund (IMF), also established a gold-dollar standard for the world’s major currencies. More specifically, only the US dollar was tied to gold, fixing its price at $35 an ounce, while other currencies were fixed to the dollar. This period, too, was characterized by rising prosperity, stable inflation rates and falling income inequality in the advanced economies.
After the Bretton Woods system broke down in 1971—when then US president Richard Nixon closed the “gold window" and severed the link between the US dollar and gold—the global economy entered uncharted territory. Never before, at least in modern economic history, were national currencies, and the central banks that managed them, left without a nominal anchor for monetary policy.
Nations experimented with different alternative systems, all under the rubric of flexible exchange rates. By the 1980s, a theory known as “monetarism" or “monetary targeting" became popular with many central banks of advanced economies. Originally proposed by Nobel-winning economist Milton Friedman as the “k% rule", under this arrangement, the stock of money is allowed to grow at the rate of k% per year, and this rate is chosen to ensure overall stability in the inflation rate.
Monetary targeting, however, failed to generate a stable inflation rate, as Friedman and others had expected, partly because money demand—and therefore the “velocity" of monetary circulation (the number of times the money stock turns over in the economy in a given year)—fluctuated much more than anticipated, so that a steady growth in the money supply did not generate a steady inflation rate.
Eventually, both economists theorizing about monetary policy, and the central bankers practising it, hit upon “inflation targeting" as the preferred system. Under this regime, the central bank targets the rate of consumer price inflation and adjusts the policy interest rate to achieve the target (or keep it within an agreed-upon band around the target).
Since today’s policy rate affects future, not present, inflation—often with a lag of several quarters—this policy is not as easy to implement as it sounds. This policy requires central bankers to be forward-looking, and decide policy today based on their expectations of inflation in the future—after weighing which is the most likely alternative future scenario. That is why Nobel-winning economist Robert Mundell has said, correctly, that “inflation targeting" is, in fact, a misnomer—the system is more accurately described as “inflation forecast targeting".
Despite the theoretical difficulties, during the 1990s and into the 2000s, inflation targeting became the policy of choice for the world’s major central banks, and for the most part, it seemed to work well—delivering low and stable inflation and high growth. Perhaps because of this success, a certain kind of hubris had set into the economics profession, and among central bankers, who assumed that the “science" of optimal monetary policy had been perfected, and could be implemented quite well in practice. According to this theory, the policy interest rate would simultaneously ensure that inflation stayed close to its target and that output stayed close to its “potential" or long-run level. It worked in the world of mathematical models and it seemed to be working in the real world.
Then the global financial crisis of 2008 hit, and both theorists and practitioners were rudely awakened to the reality that inflation targeting might not be the magic bullet it had been thought to be. While targeting the inflation rate, the conventional view was, as most famously articulated by former US Federal Reserve chairperson Alan Greenspan, that potential asset price bubbles were not something to worry about. Such “rational bubbles" should be allowed to grow and burst on their own, and monetary policy should stay focused only on inflation, according to that view of the world. What policymakers did not realize was just how painful a recession, and how slow a recovery, would follow if an asset price bubble, especially one fuelled by credit growth—exactly as occurred with the US subprime mortgage market before the crisis—was allowed to grow and then to burst.
Nor could anyone have realized the extraordinary measures—in the form of “unconventional monetary policies" (UMPs) such as near-zero interest rates, “quantitative easing" (the large-scale purchase of government securities by central banks) and “forward guidance" (explicitly announcing the path of future policy)—which central bankers would have to unleash in an attempt to jumpstart the stalled global economy. Indeed, a new worry is that UMPs themselves are fuelling new asset price bubbles, and that emerging economies such as India are especially vulnerable to the aftershocks, a point that has been made on numerous occasions by RBI governor Raghuram Rajan, most notably in London recently.
It would be fair to say today that there is no settled consensus in the economics profession on whether the experience of the global financial crisis has put a major dent into the logic of inflation targeting. The orthodox view, as expressed by major central banks and the IMF, remains that, once the current crisis is over, UMPs are unwound, and interest rates return to normal levels, inflation targeting—now augmented with “macro-prudential" policies that attempt to prick asset price bubbles before they grow dangerously large—would continue to be the best policy.
The contrarian view, as expressed by the Bank of International Settlements and lent credence in a leader in Mint, is that non-monetary tools alone cannot deal with asset bubbles, and that the strict inflation-targeting framework may need to be rethought to add greater attention to asset prices and not just to CPI inflation.
All of this brings us to the Indian situation. The idea of moving to an explicit inflation targeting regime, away from the more opaque mixed-targets approach with multiple indicators that RBI traditionally followed, was mooted in the first instance by the Urjit Patel committee set up by RBI in 2013, and which presented its report in January 2014. The other chief input into the draft IFC was the work of the Financial Sector Legislative Reforms Commission, which presented its report to the finance ministry in March 2013.
It would be fair to say that most of the commentary in India was critical of the inflation targeting proposal—as one may glean from early reviews of the Patel committee report (see, for instance, several articles in the 1 March 2014 issue of the Economic and Political Weekly). The bulk of the criticisms boiled down to the argument that the mechanism through which inflation targeting worked well in the advanced economies—in particular, the tight causal relationship between the policy interest rate and the CPI inflation rate, operating, albeit with a lag, through a well-understood monetary transmission mechanism—did not work so well in India. Monetary transmission is weak in our system since it is dominated by public sector banks and a large chunk of the population operates on a cash-only basis, the critics argued.
What is more, it was suggested that as food and fuel constitutes a large part of the CPI basket in India, and that these prices are largely supply-determined, the interest rate would be correspondingly less effective in influencing inflation. It was suggested that estimates of inflation expectations were not well-formed or at any rate appeared less anchored to reality in India than in the advanced economies. Finally, yet another criticism frequently raised was that, after the difficulty that inflation targeting had run into in the advanced economies following the onset of the global financial crisis in 2008, as discussed above, it would be unwise for India to adopt this framework.
The response would be that, no doubt legitimate as these criticisms may be, they are largely nihilistic and do not provide any sort of credible alternative to the inflation-targeting framework. The opaque mixed-targets approach followed until recently, after all, has a decidedly mixed track record, and did not generally deliver a stable and predictable inflation rate.
Even in the advanced economies, and even among those sceptical of inflation targeting, there is no viable alternative policy proposal on the table on which the critics agree. In the absence of a return to a global system of fixed exchange rates, or even a global currency, as favoured by Mundell, there is no real alternative to the current arrangement of national economies pursuing inflation targeting that are linked through a system of flexible exchange rates. It would thus make good sense to bring India up to international best practice—both in terms of the inflation target mandate itself and the MPC—and then modify the institutional structures over time based on our learnings.
Economics Express runs weekly, and features interesting reads from the world of economics and finance.
Comments are welcome at feedback@livemint.com
Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!
