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It might be time to rethink our inflation-targeting framework

The current regime seems neither suited to India’s developmental needs nor as effective as claimed

The first ever monetary policy committee (MPC) of the Reserve Bank of India (RBI) has held its last meeting. By and large, tributes have poured in for its believed role in reining in the rate of inflation in India. Simultaneously, given the recent spike in the rate of change in the consumer price index (CPI), analysts have reconciled themselves to RBI not cutting its policy rate till inflation falls. This shows the stranglehold of inflation targeting (IT) on our policy framework and mindsets. Both are unhealthy for India.

Let us be clear. Price stability matters. More precisely, a stable trend in the rate of inflation matters. High inflation acts as a tax on the poor. However, in practice, to assess its impact on them, we need the basket of goods and services from which it is calculated to be aligned with the basket of what they consume. Further, there is considerable disagreement on what constitutes high inflation. There was no basis to the 2% rate that is supposedly targeted by central banks in developed countries.

As for developing countries, India in particular, there is enough empirical evidence to suggest that a 4% inflation rate is too low a target. After analysing 40 years of data up to 2000, Robert Pollin and Andong Zhu (Inflation and Economic Growth: A Cross-Country Non-Linear Analysis, 2005), concluded that there was no justification for inflation-targeting policies as they were being practised throughout the world’s middle- and low-income countries—that is, to maintain inflation within a band of 3-5%. Madhu Sehrawat and A.K. Giri (2015) found the threshold level of inflation (above which there is an adverse impact on economic growth) to be 6.75% for India, while Wiston Adrian Risso and Edgar J. Sanchez Carrera (2009) estimated it at 9% for Mexico.

In theory, price stability is the best guarantor of medium- to long-term economic growth. But, as shown above, the threshold level at which inflation turns adverse for growth is not a settled issue, nor are the causes of inflation and the agency of the central bank in achieving price stability. If central banks were instrumental in bringing down the inflation rate in the developed world, then their abysmal failure in pushing it up, despite repeated and increasingly reckless attempts to do so, explodes the myth of their efficacy.

The inflation generating process (IGP) is poorly understood everywhere. The Bank for International Settlements (BIS) wrote in its Annual Report 2015-16: “Inflation is a highly imperfect gauge of sustainable economic expansions, as became evident pre-crisis. This would especially be expected in a highly globalized world in which competitive forces and technology have eroded the pricing power of both producers and labour and have made the wage-price spirals of the past much less likely." In this explanation, the BIS almost lays out its theory of inflation. Wages matter a lot more than central bank mandates do. Indeed, that is why inflation targeting is a political economy project.

For developing countries like India, food prices are an important part of the IGP. In the ‘Technical Issues’ that accompany the annual Article IV economic assessment of a country, the International Monetary Fund, in March 2015 (India’s Food inflation: Causes and Consequences), has documented and quantified the role played by rising food prices in generating inflation in India. During the term of the country’s first MPC, food inflation was rather well behaved. In the calendar years 2016 to 2019, food price inflation averaged 5.3%, 1.3%, 1.3% and 3.75%, respectively. This is due, in no small measure, to the moderate increases in minimum support prices that the previous National Democratic Alliance government had announced over the first three to four years of its rule.

The inflation expectations of Indian households have closely tracked the trajectory of food price inflation, and attributing it to the formation and functioning of the MPC is a case of confusing correlation with causation, as Barry Eichengreen and his co-authors do in a recent paper. This is so even in New Zealand, the first country in the modern era to target inflation (Inflation Targeting Does Not Anchor Inflation Expectations: Evidence from Firms in New Zealand, Brookings Papers on Economic Activity, Fall 2015).

In 2015, I had written in favour of India’s inflation targeting framework in the light of the experience of persistent double-digit inflation up till 2014. Now, we have evidence of its performance for four years. In those four years, the MPC had disregarded the impact of food inflation on the overall inflation performance, and relied on its own inflation forecasts, causing it to keep monetary policy too tight in 2017 and 2018. In the process, it ignored financial stability and the growth implications of the collapse of IL&FS, and thus contributed, in part, to lower growth outcomes in 2018 and in 2019.

On balance, a case can be made that India has been a precocious inflation targeter. The country may have sacrificed financial stability and economic growth in the process. So India may need to re-examine the appropriateness of the IT framework for its development needs, and, failing that, at least revisit its target rate and range.

V. Anantha Nageswaran is a member of the Economic Advisory Council to the Prime Minister. These are the author’s personal views.

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