2 min read.Updated: 04 Oct 2020, 08:40 PM ISTLivemint
Calls have arisen to abandon the use of monetary policy to control price levels. While these arguments do have some merit, we must let RBI do its job of keeping the rupee’s value stable
Once the Reserve Bank of India’s (RBI) reconstituted panel for monetary policy convenes, which ought to happen soon, signs of a slight economic uptick might spell both relief and reason to keep its main lending rate steady at 4% in the hope that inflation will cool without having to tighten credit. The operative word here is “hope". Price trends lost clarity after covid threw both demand and supply out of gear. This flux is partly why policymakers now have big questions to confront. First, should our inflation target be raised when it comes up for renewal next year? And second, should we have one at all? In 2016, when we adopted the idea of formally asking RBI to contain rising prices, it was hailed as an answer to flare-ups seen in previous years. The policy seemed effective, too. The central bank had the authority to act against the inflationary effect of, say, a burst of fiscal profligacy by the government. RBI was finally free to do its core job as guardian of the rupee’s value, thus assuring everyone a fair deal and granting our currency the stability needed to serve as a credible unit for long-range forecasts. Critics of inflation targeting, however, had argued that it was ill-suited to an emerging economy like ours. Even a flexible regime with a wide inflation band, they said, was far too rigid to foster growth. Today, as we worry about stagflation, their critique appears to have acquired some weight.
The use of a lending rate as a lever to control inflation is based on the monetarist view of prices being a function of money levels in an economy, but price spikes in India are often caused by supply disruptions, rather than excess cash floating around. Our farm sector, especially, responds too weakly to signals of demand. Given such structural rigidities, critics argue, a credit squeeze to combat inflation could simply dampen business impulses without reining back prices. In this view, the price moderation seen after 2016 should be attributed less to RBI’s policy actions and more to an overall slump in spending. This may or may not be true, and we will not know till the regime is tested against an economic upsurge. Until then, however, the link of cheaper or dearer loans with retail prices deserves a chance to prove itself. If it turns out RBI has actually acquired a handle on inflation, our 2016 shift would surely count as a reform breakthrough.
Another call to junk our inflation target draws upon the argument that only a big splurge by the state can haul India out of its corona stagnancy. If prices are let loose in the process, so be it. A fringe benefit: Inflated nominal data could make a revival look sharp and stir up animal spirits. Moreover, the extra debt burden taken on might anyway have to be inflated away. Admittedly, if push comes to shove, this could plausibly work. Since our currency is partly convertible, RBI might even get goaded into it by a dollar insurge; vast greenback purchases to keep the rupee from getting overpriced could inject our economy with too much local cash to sterilize. Yet, we must not act in haste to abandon inflation targeting. Price stability is a goal too worthy to give up on. For the sake of fairness, if not the rupee, we should resist the temptation to use the “money illusion" of inflation for short-term ends. Most voters would probably agree.