The fall guy

Indian Express, 28th May 2016

Successful inflation targeting calls for more reform. Targeting Governor Raghuram Rajan is all too easy.

Subramanian Swamy's comments, though aimed at RBI governor Raghuram Rajan personally, have significance for the inflation targeting framework of the RBI. In the Budget Session of parliament, the RBI Act, 1934, was amended as part of the finance bill. Inflation targeting has now become law. Soon, the government will notify the level of inflation it wants the RBI to target in the next five years. I argue here that in the present circumstances the target inflation rate should be five per cent. Successful inflation targeting requires reforms that have not been implemented so far. Without a well-functioning bond market, end of financial repression, a competitive banking sector, an independent government debt manager and full understanding and commitment on part of government to low and stable inflation, inflation targeting will be a pipe dream.

In the last 25 years, the RBI has sometimes raised or lowered policy rates in order to control inflation either of its own account, or, since last year, as part of a formal agreement with the government. The Monetary Policy Framework Agreement (MPFA) signed in February 2015, for the first time, put in place an inflation target agreed upon by the RBI and government. As a first step towards making a commitment to low and stable inflation, this was a significant step. Many an expert committee had recommended that India should do what most other countries, including emerging economies, had done, and adopt inflation targeting as the objective of monetary policy. This framework was formalised with the signing of the MPFA.

In the past, the RBI had not systematically used either Consumer Price Index (CPI) or Wholesale Price Index (WPI) as the inflation target. However, the MPFA made CPI the mutually agreed target. Since then it was no longer Rajan's unilateral decision to move from WPI to CPI, as Swamy believes. More so, last week through the amendment to the RBI Act, Parliament made CPI the target. But the main reason for Swamy's unhappiness with the target appears to be the high interest rate regime under Rajan. This, no doubt, is hurting industry and employment.

What should the government do to help ensure that the objective of low and stable inflation as well as economic growth is achieved?

First, the government has the responsibility of notifying the inflation rate that it wishes to achieve. This rate is to be set every five years. The inflation target in the MPFA chosen by government and the RBI was 6 per cent by January 2016 and then 4 per cent for 2016-17 and thereafter (with a band of 2 per cent). This sudden jump down in the inflation rate appears at odds with the stated intent outlined in the Urjit Patel Committee report of setting a glide path to inflation. A glide path in the case of other countries such as Chile and the Czech Republic, cited in the report, was slower and smoother and a lowering of the target was done when the existing target was achieved and stabilised.

For India, a glide path would have meant that the economy reaches a stable 6 per cent, becomes comfortable with it, and then only the target is lowered to 5 per cent. If 4 per cent is the long-run stable target, as argued in the Urjit Patel Committee report, it would be unrealistic to jump straight to it.

Second, the government and the RBI should together review India's first experience with formal inflation targeting. One of the well-known problems with monetary policy in the past one year has been the lack of transmission. It appears that given the lack of other reforms in the financial markets such as the creation of a well-functioning bond market, a competitive and market-oriented banking system, and a bond-currency-derivative nexus, monetary policy transmission does not happen easily. In this set-up, it is unlikely that the three-year path to a low and stable inflation envisaged in the MPFA can be achieved in a hurry.

It is important that we ask whether more reforms are needed before the target is lowered. Even if the government decides to lower the target, it should consider moving it from the present 6 per cent to 5 per cent. After transmission improves, inflation stabilises at 5 per cent and inflationary expectations come down, in the next setting of the inflation target five years later, the target could be brought down to the long-run target of 4 per cent.

Third, if the government wants to give the country low and stable inflation by adopting an independent monetary policy, it should clearly signal that it does not want the RBI to peg the exchange rate. One reason for the high interest rate regime has been the reluctance to ease liquidity after the shock to the rupee following the taper talk in May 2013. The unstated mandate of the RBI seems to be that it has to manage the exchange rate and prevent it from depreciation.

Fourth, the government needs to put an end to the foolish notion that the RBI can target WPI. The bulk of the items in WPI are tradables. Their prices are determined in international markets. WPI inflation closely follows the US producer price index based inflation rate. Inflation in WPI is determined by global commodity prices and not by domestic monetary policy. In other words, targeting WPI would be akin to targeting global commodity prices, something no central bank has control over. It is not surprising that no country ever tries to target it.

From the point of view of the domestic mandate, inflation measures based on CPI are the most common target for inflation-targeting countries. A couple of countries strip CPI of volatile food prices, but most central banks mainly use such a concept of “core inflation” in their internal models. CPI is the measure consumers relate to. WPI does not represent anyone’s basket, and at best, represents the price of inputs and outputs for producers. The choice of CPI is superior to the WPI because it measures the cost of living for consumers. Even though food is volatile, but because it matters to households, it is the rise in cost of living they care about. After all, governments adopt inflation targeting as the mandate they give to central banks because they want voters to have low and stable inflation. Incidentally, they also hand over this task to central banks so that if people get unhappy, such as with rate hikes, it is the central bank that gets blamed. Swamy seems to be doing pretty much that.