Central banks may need greater flexibility in targeting inflation
Cost-of-living readings are likely to stay volatile in the years ahead and so monetary policy targets might require revision
India’s latest inflation number at 7.4% comes as a shocker, with doom-speak all around. This is so because we have been talking of getting to 4%, which was axiomatically taken to be the ideal mark. This is analogous to the US, which has a target of 2%. But we need to pause and reflect on two counts.
The first is that inflation will always surface at higher than accepted levels periodically across the world and there are no quick fixes. If governments and central banks can bring inflation rates down to their targets with ease, then price stability would reign. The fact that all governments and central banks struggle means that authorities can at best try and make a difference at the margin, but are ineffective beyond a point. Rates are raised to plug away at the demand side. This cannot be done in one stroke, so policy interest rates that need to rise by 300 basis points, say, are pushed up in smaller-sized hikes spaced out across time.
But what of the supply side? At the policy level, the government can make changes in the foreign trade rules of engagement. The exports of sensitive items like foodgrains can be banned, for example, which is not good for globalization but serves domestic interests. Imports can be used to fill supply shortfalls, but once prices go up, it is hard to ensure that these imports reach far and wide enough to soften them adequately.
At another level, stock limits could be imposed to prevent hoarding, but if this is not a cause of rising prices, then it only creates panic and has self-fulfilling effects. This is what we have witnessed in India recently. Buying food products at a higher cost and selling cheap, as was done for tomatoes by New Delhi, is not sustainable beyond a month or so and cannot cover the entire population of a state. Therefore, inflation once it erupts, has to be worked upon and reduced gradually. One refuge is the statistical base effect, by which a high base of prices the previous year makes a year-on-year rise look benign. This is likely to happen around September or October even if prices stay elevated.
The second point to ponder concerns monetary policy. Are we targeting the right inflation number? A 4% target for India or 2% target for the US may have been relevant at a particular point of time. Post-covid, we have had high price volatility as many supplies have not regained normalcy on account of various factors, including the ongoing war in Ukraine.
Let’s take a practical view of the current situation. The Great Moderation phase is over, and post the Great Recession, the assumption that globalization will proceed with full force no longer holds. Countries are more inward looking, placing emphasis on domestic considerations. While a band of 2 percentage points on either side of an inflation target does offer elbow room to central banks with a flexible mandate, the main target should be placed under consideration for change based on evolving conditions.
Data shows how India has fared on inflation over the decades. The accompanying table shows inflation rates on a monthly basis for the Consumer Price Index (CPI) since inception. The headline number has been considered because this is what is targeted by the Reserve Bank of India (RBI). The period taken is up to July 2023. The inflation series can be analysed in three blocks. The first is for the entire period, the second is for the pre-July 2016 months, as this cut-off marks the point when RBI’s Monetary Policy Committee was formed and flexible inflation targeting formally got underway, and the third captures the inflation record after this shift. The table gives the number of months when the CPI inflation rate fell in different rate ranges. Monthly inflation is relevant as policy decisions are based on these trends.
After July 2016, in only 23% of the months has inflation remained at 4% or below, while for 52% of the instances, it has exceeded 5%. In fact, in 35% of the months after the MPC was set up, inflation has been above 6%, while it has been between 5% and 6% for 16% of the months. Therefore, there exists a practical argument for revising the central target to 5%, up 1 percentage point. If we look at the entire data series of 139 months (over 11 years, i.e.), the table shows above-6% inflation in 42% of the months and above 5% for 62% of the months.
We can also examine the pattern of inflation in the US, where the 2% target has been maintained, though, as the Federal Reserve website says, this is an average it aims for “over time." What does America’s record look like? For the eight years ending December 2020, out of 96 months, on 58 occasions (60%), the US inflation rate was within the 2% mark. For 26 months, inflation was between 2% and 2.2%, showing 10% variation from the Fed’s target, and for the balance 12 months, the variation was up to 20% (i.e. inflation of 2.4%). However, if the US series is extended till July 2023, then in 66 of the 127 months (47%), inflation has crossed 2%, with 28 months exhibiting inflation of above 2.4%.
There are two conclusions which can be drawn from all this. The first is that the world has changed significantly over the last 5-7 years and inflation can now be expected to be volatile. As countries rebuild their economies amid supply turbulence, higher demand for goods and services could push up prices further. Second, monetary policy should be flexible in targeting inflation, and we need to debate target revisions. This is relevant not just to India, but also the rest of the world. The US, for example, may need to reconsider its 2% goal. While it is possible that conditions will revert to the mean at some stage, and maybe 5-10 years down the line these targets would again be suitable, changing the target for the short to medium term would send better signals to markets at large.
These are the author’s personal views.
Madan Sabnavis is chief economist at Bank of Baroda and author of: ‘Corporate Quirks: The Darker Side of the Sun’
