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Questions that still hover around our monetary policy framework

The first four years of the Reserve Bank of India’s inflation-targeting framework could offer lessons for the journey ahead

The first monetary policy committee (MPC) appointed by the government to decide the benchmark interest rate in India ended its term this month. A lot has already been written on the voting pattern over the 24 meetings of this Reserve Bank of India (RBI) committee. A new MPC has to be appointed soon under the existing rules. The central bank’s inflation target has to be reset a few months later in April 2021.

How should the lessons of the past four years inform the journey ahead? This column takes a look at three important questions—on the inflation target, on the choice of nominal anchor, and on coordination of monetary policy with fiscal policy. Some of these questions are likely to dominate policy debates in the coming months.

Question one: Does India need a new inflation target? It is well known that the committee on the new monetary policy framework had in its 2014 report recommended that India’s inflation target should be 4%, with a wide band of two percentage points on either side to take into account unexpected supply-side shocks, such as a jump in food prices, which account for nearly half of the Indian consumer price index.

This level of threshold inflation—or broadly the level of inflation that maximises growth—was more or less in tune with what nearly 30 years of empirical research had yielded. The Sukhamoy Chakravarty committee had estimated threshold inflation at 4% in 1985. The RBI annual report released in 2011 had come up with a range of 4-6%. Other studies have broadly come to similar conclusions. The inflation target given to RBI by the government is thus not out of sync with these earlier estimates.

The government may consider increasing its inflation tolerance level when it gives the central bank a new target next year. A higher inflation target would give the next MPC more room for monetary easing. However, a higher target should ideally be empirically grounded rather than picked out of thin air. And India’s inflation target cannot be delinked from the overall global inflation trend, more specifically inflation in our major trading partners as well as countries that Indian exporters compete with in global markets.

Question two: Should core inflation be the nominal anchor of monetary policy? RBI targets consumer price inflation, dominated by food prices that do not respond to monetary policy. So should it shift its nominal anchor to core inflation? I was one of the economists who had made this suggestion to the Urjit Patel committee in a meeting held in December 2013. The committee chose headline over core because inflation expectations react to changes in the overall price level rather than only a part of it. Thailand, which was the only economy that used core inflation as its nominal anchor for monetary policy, shifted to targeting headline inflation.

Few realize that core inflation continues to be tracked closely by monetary policy authorities. RBI’s forecasting model—the Quarterly Projection Model—parts ways with standard central bank models by treating core, food and fuel inflation in three separate equations. The Philips Curve in the model is sensitive to the gap between core and headline inflation. Food prices influence the core through changes in inflation expectations.

Core inflation is part of the analytical framework. Some recent research shows that as inflation expectations have got anchored, sudden shocks to food and fuel prices do not unsettle core inflation (Changing Dynamics of Inflation in India, by Ravindra Dholakia and Virinchi S. Kadiyala, March 2018). Even shocks to core inflation tend to dissipate faster than before. Such a decline in inflation persistence is at least partly because of the rising credibility of monetary policy in recent years. A shift towards core inflation targeting—either in law or in practice—is dependent on how confident citizens are about the ability of Indian economic policy to meet its fiscal and monetary targets.

Question three: Should fiscal and monetary policy work in tandem? There is a good reason to ask this question. Fiscal spending has in recent years been a big part of incremental aggregate demand in India, thus influencing inflation. And lower inflation via RBI has impacted the government budget by bringing down the rate of nominal economic growth. This column has earlier argued that India’s fiscal and monetary targets should be set through a common analytical framework, and that the government budget should be designed with RBI’s inflation target in mind.

A lot depends on the political economy. Kenneth Rogoff had famously argued in a 1985 paper that a central banker with lower inflation tolerance than the political system will increase social welfare. The idea of central bank independence is now under attack. The existing division of labour is a sensible one. The government as a representative of the Indian people gives RBI an inflation target for the medium term. The central bank should then have the requisite operating freedom to pursue the target, while being insulated from the inevitable political cycles.

In an insightful paper published in March 2007, Alberto Alesina and Guido Tabellini showed why rational politicians tend to delegate to unelected bureaucrats those tasks that they can get blamed for by voters, while keeping control of those tasks that involve redistribution. Think about it the next time someone asks why an unelected MPC sets interest rates.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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