Photo: Abhijit Bhatlekar/Mint
Photo: Abhijit Bhatlekar/Mint

Opinion | Why inflation targeting in the country is a rip-roaring success

Those who argue India does not need RBI to target inflation because it is already low have got things completely backward

By now, the well-established laundry list of the Narendra Modi government’s economic reform accomplishments in its first term in office reads: Goods and Services Tax (GST); Insolvency and Bankruptcy Code (IBC); and Monetary Policy Framework Agreement (MPFA) to enshrine inflation-targeting administered by a Monetary Policy Committee (MPC). Of this tripod, the first two legs are already shaky, as the GST has proved cumbersome and distorting, and fallen short of its revenue target, and the IBC has been all but gutted by unfavourable court rulings. Unfortunately, there is a serious danger that the MPFA, the one genuinely original and important policy reform of the Modi government that was not an inherited legacy from the previous government, will also be knocked away, and the tripod of reforms accomplishments will come crashing down.

It is no secret that industry hates sound monetary policy, which tightens when inflationary pressures loom and loosens when inflation is quiescent. Big businesses love cheap credit and so they like low interest rates; they don’t worry so much about the inflationary consequences, which hurt the average consumer, not the captains of industry. Likewise, no minister of finance worth his or her salt is ever going to complain about low interest rates, as it makes financing government debt cheap in the short run, while the inflationary costs will be the headache of the next bloke in power or the central banker. This inherent conflict of interest between fiscal and monetary authorities is at the core of the rationale for an independent monetary policy.

It also is self-evident that economists, commentators and journalists, who typically tend to shill

for industry, government or both, are likewise advocates of low rates, the inflationary consequences be damned. Thus, one has already started to see the drumbeat of commentary calling for large rate cuts from the MPC.

Apart from these motivated calls for lower rates, another fact-free but constantly repeated assertion is that low inflation, as delivered by the MPC’s hawkish monetary policy stance, has skewed the terms of trade against agriculture and, so, worsened rural distress. This is an argument one hears both from right-wing supporters and left-wing critics of the government, so it is at least politically agnostic, although it is bad economics.

For this theory to be correct, it requires nominal prices in the agriculture sector to be flexible, while nominal prices in the rest of the economy (call it industry for short) are slow to adjust—“sticky", in the language of macroeconomics—so that other things being equal, lower inflation results in a worsening of the terms of trade of agriculture vis-a-vis industry. The fly in the ointment is that there is neither a conceptual basis nor evidence for this differential price stickiness; nor, even more basically, do the terms of trade seem to have turned against agriculture when disinflation began in 2014, as the theory posits. This is simply a canard that should be put to rest once and for all.


It is salutary to remind ourselves, therefore, that inflation-targeting has been a rip-roaring success in India. Indeed, it’s the dog that didn’t bark in the recently concluded election campaign. While there was a litany of complaints about stagnating incomes and sparse job opportunities (none of which seems to have affected the election outcome, but that is a tale for another time), no one complained about an inflation problem because—guess what?—there wasn’t one.

Some useful perspective can be gained by looking at the recent track record. The chart above shows consumer price index (CPI) inflation on an annual basis from 2004 to 2017. The shape is that of an especially challenging ski slope, with a gentle rise and peak in 2010, followed by a sharp drop the following year, and then another sharp increase, peaking again in 2013 at double digits. You might call it the “twin peaks" inflation legacy of the previous Congress-led government in the latter days of its last innings.

And, what has been the story since then? Indian inflation has been steadily declining, and has been within the two percentage point tolerance band around the 4% target since 2015. Indeed, there is an evident structural break in the data in 2014-15, or the period that the Modi government came to power (May 2014) and that the MPFA was adopted (February 2015). You don’t have to have a PhD in economics from an Ivy League university or have studied with Nobel laureates (although neither could hurt) to see that inflation-targeting has worked, period.

The joke is that those who say we don’t need inflation-targeting because inflation is already low have got things completely backward: The truth is we now have low inflation because of inflation targeting, not in spite of it or just through sheer luck.

It is worth reiterating that the adoption of the MPFA, which built upon the recommendations of the Urjit Patel Committee report released by the Reserve Bank of India (RBI) in January 2014, remains the Modi government’s most lasting, important, and original economic policy reform accomplishment. Unfortunately, as I have warned in this column, after the unsightly hounding out of former RBI Governor Patel in December 2018, the Modi government appears to have developed an inexplicable appetite for shredding its own most significant economic policy accomplishment.

Vivek Dehejia is a Mint columnist

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