Miss the Wood for Inflation Targeting

Context: Inflation targeting hasn’t really served India’s purpose. It’s time to change our views on its potential use and change track.

Drawbacks of Inflation Targeting:

• Biased towards Consumer Price Index (CPI): It is based on an assumption of linear monetary policy on a specific inflation index, that is neither empirically robust nor flexible with dynamic demands.
  • More than 50% of CPI is food and fuel (essential commodities), making it structurally immune to interest rate nudges. (both are inelastic to price movements)
  • Food prices in India are governed via minimum support prices, while fuel prices are governed by global crude oil prices.
• Over-estimation of inflation (singular focus on inflation): High real interest rates have hurt investments and fiscal capacities.
  • It encourages foreign portfolio to carry trades, which forces RBI to buy foreign exchange to prevent the rupee from appreciating sharply, and further increases the government’s fiscal burden.
• Widening of the inflation targeting band: A wider band reflects the primacy of political economy objectives over a techno-legal one.
• Mixed global examples: Brazil and Indonesia has stable targeting but underperformed in macro outcomes. While Turkey has seen the fastest decline in an emerging market currency.
  • To the contrary, the US Federal Reserve has a dual mandate of inflation and employment.
• India’s complex economic issues: Large number of poor, requirement of high economic growth to absorb a young population coming into the workforce, structural Current Account Deficit (CAD).

Way Forward:

• Outcome targeting approach: Monetary policy should change dynamically along with changes in the political economy, rather than being frozen in time by law.
  • RBI shall have a trinity of objectives: growth, CAD and inflation.
  • Government should define baseline tolerance level for all three to RBI, rather than a fixed band.
  • It should also determine the rank order primacy of the three for RBI to modulate policy around.
• A coordinated fiscal-monetary push, with RBI monetizing, either directly or via a foreign exchange swap, a large fiscal intervention to back-fill the weakness in aggregate demand.
  • Target of the intervention - consumption, health, education, cash transfers, variables that quickly take consumption up (not large infrastructure projects that are time and process-constrained).
  • Bring down the interest rate term spreads (that between the 10-year government security (G-sec) and repo rate is almost 2%).