Inflation targeting is no miracle cure but it’s the best available

The debate over the suitability of flexible inflation targeting (FIT) for India again gained momentum after a recent presentation by a group of economists (bit.ly/3d0gncy). The backdrop of this attack on the FIT regime is the announcement that the Reserve Bank of India (RBI) is to continue with its Consumer Price Index (CPI) inflation target of 4% +/-2% for the next five years.

The presentation makes the following key claims, among others. First, FIT led to higher than desired real interest rates, with adverse consequences for economic growth, in recent years. Second, the moderation in inflation under the FIT regime is almost exclusively due to a consistent decline in global inflation and slower increases in minimum support prices for farm produce, and should not be attributed to the policy shift. Third, the trend of inflation in India had begun to decline even before FIT was put in place half a decade ago.

Let us evaluate these arguments. There are indeed other precedents of central banks having forecast inflation to be higher than the actual, as in the Bank of England’s case during 1992-95, which led to an overly restrictive monetary policy. In general, errors in economic forecasts stem from imperfect forecasting models, incomplete information or misinterpretation of the state of the economy, unforeseen events such as demonetization, sudden and frequent changes in tax structure (example: the goods and services tax), and changes in the prices of volatile items like food and fuel. There is, however, another crucial factor to consider.

RBI’s forecasts released in the public domain appear to be based on a technical assumption of an unchanged repo rate during their duration. For example, in its latest monetary report, RBI forecasts CPI inflation during January-March 2023 at 4.7%. This would be based on the assumption of today’s repo rate. Had RBI cut the repo rate this month, then its likely transmission into higher actual inflation two years ahead is not inbuilt in the current forecast. If the monetary policy action turns out to be effective, then actual ex-post inflation would tend to be higher than the forecast today. The same would hold in the reverse case. Comparing inflation forecasts and actuals when the former does not account for the impact of policy rate changes is not appropriate.

Second, the presentation argues that inflation moderated across the world on account of softer global oil prices. In essence, RBI benefited from good luck that coincided with the roll-out of its FIT regime. The role of luck in monetary policy outcomes has been long debated. Ravenna and Ingholt test the good luck hypothesis with the inflation experience of Canada, one of the earliest adopters of an FIT regime. They conclude that luck can explain only a minor portion of changes in the path and volatility of inflation, while most of it is accounted for by the regime’s impact on expectations.

In contrast, Hornstein, Johnson and Rhodes, writing in an economic brief of the Federal Reserve Bank of Richmond in 2015, concluded that bad luck was a plausible explanation in a sequence of one-sided misses to the Fed’s inflation target after 2012 (bit.ly/2RmDlSY). The luck factor in that context was none other than high global oil prices. RBI, too, in its Report on Currency and Finance 2020-21 acknowledges the role of luck. However, the extent of the roles played by structural and policy changes, and by luck, need to be studied carefully before attributing outcomes largely to a single factor.

The presentation’s third argument is that inflation in India was trending down before the FIT regime’s adoption. But what now appears to be a trend may not have turned out to be so had inflation not remained under control in subsequent years. As for its contention that an unduly restrictive monetary policy led to growth running below its potential rate after 2015, such an assertion needs to be supported by a counter- factual analysis. Had the repo rate been lower, would it have raised the growth rate, everything else being the same?

The growth rate drop could have had more to do with the shock of demonetization, disruptions caused by the GST roll-out (and changes therein), and an unresolved banking-sector crisis. Given these factors, lower real interest rates and higher liquidity may have been insufficient to spur economic expansion.

As Bernanke and Mishkin wrote in 1997, inflation targeting should be viewed as a policy strategy that “constrains the central banks from systematically engaging in policies which have undesirable long term consequences but which allows discretion for dealing with unforeseen or unusual circumstances”. This is the spirit in which FIT central banks around the world are currently allowing higher inflation than their existing targets.

In any case, it’s unclear what credible alternative to flexible inflation targeting exists that combines a rule with discretion. It is widely accepted that the earlier multiple-indicator approach did not provide a clearly-defined nominal anchor for Indian monetary policy. The RBI experience of 2009 shows how multiple objectives and indicators can lead to a costly policy error. Overall, abandoning the FIT regime would do more harm to India’s growth prospects and stability than aid it.

Vidya Mahambare is professor of economics, Great Lakes Institute of Management, Chennai