2 min read.Updated: 23 Feb 2021, 09:01 PM ISTLivemint
The CEA’s argument of supply constraints blunting RBI’s policy tools is not new. Nor does it justify easing our inflation target. Let’s not hobble this effort now that its real test is upon us
Just weeks after India’s principal economic adviser Sanjeev Sanyal hinted that the government favours sticking with India’s inflation target when it comes up for review next month, the country’s chief economic adviser (CEA) K.V. Subramanian has sought to reopen an old debate on the issue. Unlike Sanyal, who said that our 2-6% inflation band with 4% as its median target had worked well and needed no revision, his superior adviser at the finance ministry has argued that it needs refinement. Subramanian’s argument, made on Monday, was that while monetary tools of the Reserve Bank of India (RBI) mainly address demand-side factors, Indian inflation tends to track food prices which depend primarily on supply-side variables. A policy of tighter money, he implied, would not be very effective against edibles priced up by actual shortages. It may be better, in his view, to go after core inflation, which excludes volatile items like food and fuel. The CEA’s contention is not new. Nor is his ‘core’ proposal. Indeed, they were aired even before RBI formally adopted its inflation-targeting framework in 2016, mostly by analysts who parse price charts, and do hold some appeal. Yet, we should retain the status quo.
While it is true that supply constraints play an oversized role in the price dynamics of many items, this has been the case all along. And it does not justify a shift. To see why, focus on the big picture instead. The key variable that needs stability is the rupee’s actual value. What erodes it is overall inflation—too much money chasing too few products. The supply of money matters a lot. In fact, the monetarist hypothesis that inflation is always a monetary phenomenon everywhere has checked out fairly well in India so far. After a double-digit spell about a decade ago, inflation has stayed mostly tame ever since RBI aimed its tools at it. Granted, their efficacy has not yet been tested against fiscal dominance of the kind India has recently re-adopted, but that is exactly why we must give RBI a chance to prove its mettle on this front under new circumstances. Notably, its governor Shaktikanta Das has expressed confidence in the extant system and advocated retaining its current target. If it works out well, India will finally have a reliable handle on price levels, a significant gain for the country.
In any case, this is an inadvisable time for any policy tweak that would let RBI ease off on general price stability. This goal is particularly important at this juncture, now that both fiscal and monetary policy in India have been loosened to aid an economic revival. There will simply be more cash to go around. Plus, there is the inflationary pressure of capital inflows from abroad. As our economy was weakening even before its covid upheaval, some reflation will surely help. But a tolerance of inflation that lets real rates of interest go negative for too long is a risky game. It can warp incentives in our market for credit and cause resource misallocation. All considered, a dovish turn taken by RBI in 2021-22 would risk letting prices slip out of control. At one level, this may suit a debt-laden government, tempted as it would plausibly be to inflate its burden away, but at what cost? The rupee will buy even less and we would’ve squandered our hard-earned gains of the past half-decade or so. For the sake of macroeconomic stability, we must not loosen controls. As RBI’s Harendra Kumar Behera and Michael Patra argued in a recent working paper, “If it ain’t broke, don’t fix it."
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