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%).