In the meantime, the covid-19 pandemic has brought in its wake enormous economic uncertainty. Once the current economic contraction in 2020-21 passes, low growth and medium to high inflation may be with us for a year or two. In the meantime, the US Federal Reserve has signalled that it would actively seek and tolerate higher inflation in America.
Given these extraordinary and historical developments, what should be the operational target for the Reserve Bank of India in the coming years? Should the monetary policy continue to be based on FIT or something else? What would serve India better? To come up with the answers to these questions, it is important to first examine the role of central banks in managing inflation in developed and developing nations, which could then potentially offer an alternative to FIT for India.
The Reserve Bank of New Zealand (RBNZ) adopted inflation targeting formally in February 1990. It was the first country to do so. Graeme Wheeler was the bank’s governor for five years, from 2012 to 2017. Since RBNZ showed the way for modern central banks, it was only appropriate that RBNZ again show the way for the paradigm shift that is needed.
Graeme Wheeler delivered a set of remarks on central banks and their omnipotence in an honest speech in October 2015. He said, “Monetary policy was, however, relatively powerless to influence the decisions that determine long-run economic performance and distributional outcomes. For example, over the long run, monetary policy can do little to generate higher spending by households and firms. Even in the shorter term, monetary policy’s influence may be low in an environment where debt levels are high and where there is considerable uncertainty about economic prospects. Monetary policy can influence risk-taking in asset markets, but this does not necessarily translate into risk-taking in long-term real assets—requiring the investment and entrepreneurial decisions that underpin productivity growth and hence long-run improvements in living standards. Similarly, the Reserve Bank (RBNZ) is unable to influence long-term real interest rates. These are affected by a range of factors, including global savings and investment flows, risk premia and expectations for economic growth and inflation. Monetary policy can only influence short-term interest rates and, over the medium-term, actual and expected rates of inflation."
He got everything right except the last observation on being able to influence actual and expected rates of inflation. That is a myth. Central bank’s do not influence almost anything in the list above.
A survey done in his own country and presented at the annual Brookings Papers on Economic Activity concluded that even firms did not form their inflation expectations based on central bank’s inflation target and monetary policy framework. That did not anchor their expectations as much as the visit of the executives to supermarkets did.
In that sense, firms behaved little differently from households. Central banks’ inflation targeting does not influence the public—households or businesses.
Further, central banks’ failure to raise the inflation rate in the last ten to twelve years (US, UK and Europe) and in the last three decades (Japan) are powerful proofs against Wheeler’s claim with respect to the inflation rate. At the same time, they are powerless to influence economic growth too. So, the mitigation for the ill-effects and consequences of an inflation-targeting central bank is not to add economic growth as an objective but to hold them responsible for what they can actually control. That does not include inflation or economic growth. That is only credit growth—of both bank and non-bank varieties. They can control that through monetary and regulatory policies.
The hard truths
Inflation targeting began to rise as a mandate for central banks in the 1980s because of a series of events: The experience of high inflation in the 1970s; the need to bring down long-term interest rates as economic growth had stalled after the post-WWII boom had run its course; to constrain the power of elected representatives and to vest more powers with ‘disinterested’ (and, therefore, democratically unaccountable) elites and experts; and, finally, but most importantly, to restore the balance of power to capital away from labour.
Despite the acceptance of Milton Friedman’s logic of monetarism (the assertion that variations in money supply have major influences on national output), the deployment of the Phillips curve was an acknowledgement of the influence of the labour market over inflation. But, it was only partial because a low unemployment rate did not mean an incipient rise in wages. Globalisation had seen to it that it did not happen because the pool of available labour had expanded. The money supply was and is relatively powerless to do so in the developed world in the face of job insecurity.
Of course, as Fed Reserve chairman Paul Volcker demonstrated, central banks can bring down the inflation rate successfully but at the cost of engineering a severe recession. They should be wary of encouraging risk-taking and stoking bubbles because they are loath to induce caution and deflate bubbles. That is unpopular. So, even in this limited realm, the effects are asymmetric because central banks are constrained in one direction.
Unfortunately, central bankers are unable to or unwilling to accept these hard truths and keep making more and more mistakes, weakening economies and dividing societies.
In the developing world, supply-side rigidities (and that includes both labour and capital productivity), food prices, fiscal profligacy and fiscal dominance of monetary policy are more influential than wage costs, which is the case with the developed world. However, it is important not to overstate the case of fiscal policy and fiscal dominance of monetary policy as influential factors. They are policy-driven, whereas the role of supply rigidities and food prices is more structural in nature.
Further, experience has shown that, in developing countries, it is relatively far easier for the central banks to push up the inflation rate than it is possible for them to lower it.
Therefore, in comparison to their counterparts in the developed world, they are more influential in pushing the inflation rate higher because the enabling conditions are prevalent in their countries than in developed countries. The tinder is there. It is easier to set off a blaze.
They share a similarity in their ability to lower the inflation rate but at a price. The difference is that the price they pay in terms of growth sacrifice is higher, given their relative states of economic development. In a limited way, India’s experience with inflation control success in 2017 and in 2018 demonstrates that.
Therefore, the submission is that an inflation targeting regime is ill-suited for central banks in all countries—developed or developing—for different reasons. We know the reasons for its adoption and economics was only one of the factors and a minor one at that.
Even that minor economic logic must be questioned because all reasonable men and women can agree that no economic theory or policy framework is valid for all seasons and all places.
The Indian experiment
In India, the consideration of inflation-targeting was necessitated by six years of high inflation between 2008 and 2013 (both years included). As per IMF data, on average, CPI inflation rate in those years in India were 9.1%, 12.3%, 10.5%, 9.5% 10% and 9.4%, respectively. One should not ignore the role of (intellectual) fashion. I subscribed to the fashion too, then.
But, in truth, it is ill-suited for developing countries as it is for developed countries. It is not fair to hold central banks responsible for an outcome over which they have either little control or, at best, asymmetric influence. In developing countries, their striving for success to keep inflation rates at or below target comes with unacceptable economic costs, just as their striving to keep it at or slightly above target comes with unacceptably high costs for developed countries.
At the same time, this does not mean that their mandate should include economic growth for it is even less susceptible to their influence than the inflation rate. They should focus on the variable that they can control. That is credit growth, both from banking and from non-banking channels. The central bank controls external commercial borrowings too.
If central banks redefine their mandate as control of overheating rather than targeting a rate of inflation over which they have very little control, they will be helping the economy better. Overheating manifests in credit growth, in asset markets (financial and real), and in trade deficits even if does not manifest in the rate of inflation all the time. Focusing on overheating more broadly also helps in ensuring financial stability which an inflation targeting regime does not achieve.
Of course, it is important to bear in mind that changes to policy regimes should not be capricious and not be dictated by proximate experiences alone. Doubtless, they play a role in triggering a review. But we should be careful not to overweight it. Just as the high inflation rates of 2008 to 2013 played a role in India opting for an inflation targeting regime, recent anxieties about India’s growth outlook near-term and medium-term should not be the principal motivations for a review of the inflation targeting regime. In other words, the alternative chosen should be seen to work both during low and high inflation regimes. India’s multiple indicators approach that was in vogue from 1998 to 2016 offers itself as the choice.
It had served India well (see Chart 1). India comes off quite well even when evaluated against the low inflation performance of emerging and developing Asian nations. India’s inflation rate significantly exceeded that of its reference group only since 2008. That is, of course, explained by a loose fiscal policy and a fiscally-dominated monetary policy.
The RBI should define overheating more broadly than only through inflation. Apart from the inflation rate, overheating manifests itself in trade deficit and in asset (financial and non-financial) price bubbles. Hence, managing credit growth through monetary policy and regulatory measures could not only rein in inflation but also other imbalances, of both real and financial variety. Thus, an ‘overheating’ mandate will also ensure financial stability.
Consequently, India should consider returning to its ‘multiple indicators approach’ that served the country well except for the period between 2008 and 2013 when monetary policy was fiscally dominated. If that is not favoured, India’s central bank should target credit growth—through banking and non-banking channels.
The government, on its part, should work to remove structural supply rigidities both in the farm and in the non-farm economy. Principally, that involves removing the legal, regulatory and compliance burden and access to finance for small and medium enterprises, including working capital availability.
V. Anantha Nageswaran is a member of the Economic Advisory Council to the PM. These are his personal views