Reviewing Inflation Targeting

 

In 2016, India officially adopted inflation targeting as the objective of the monetary policy. With five years elapsed since the Urijit Patel committee submitted its report and later adopted, the Reserve Bank of India (RBI) is all set to review the policy. The committee headed by Urijit Patel had suggested 4% as the targeted inflation with of course a permitted band of plus or minus two percent. In other words, the RBI policy would have to ensure the inflation remains within the range of 2-6%. The repo rate was made the benchmark interest rate around which the RBI stance would revolve. Based on the data and evidence, it was believed that 1.25% would be the ideal real repo rate. In other words, at this real repo rate, the economy grow at a level it would have grown if there was full employment. This was something akin to what Philips Curve would have projected around. The four percent inflation mark was perhaps viewed in the Philips Curve terminology as non-accelerating  inflation rate of unemployment or NAIRU as it is called.

 

There is no doubt that barring the crisis induced by the Chinese virus the inflation rates have remained within the band. In the pandemic induced year of 2020, there have been occasions where inflation has breached the upper mark of 6%. At this stage where RBI sets in the review towards a possible change in its goal, there are numerous views that are on the horizon that seek to do away with the inflation targeting. Their view is the opportunity cost of inflation targeting its high. As one is aware, the control of inflation has its trade-offs. Every percent of inflation that is sought to be controlled would result in some sacrifice in the growth rate of the GDP. This sacrifice ratio comes into play during inflation targeting. The argument of this school of thought is the inflation control in India has not emerged with the RBI policy but has rather been accompanied by the lowering GDP growth rate. To them, evidence is clear, that the GDP decline began with the commencement of inflation targeting.

 

Furthermore, there is a dispute on benchmarking the real repo rate. The RBI would focus on WPI in the initial days. Yet the then RBI Governor Raghuram Rajan shifted the focus of the RBI monetary policy towards CPI. In most countries, the primary measure for inflation is the CPI whereas in India for very long, the WPI was considered a benchmark for inflation. This was done more of ease of calculation. As India moved to CPI as primary indicator of inflation in 2013, the benchmark for interest rates too would have to shift towards CPI. Yet interestingly, while the consumers would link their purchase basket to CPI, the corporates would do so with the WPI. In other words, the real rates for corporate lending and thus investment would have to be linked to WPI and not CPI. Till the financial crisis of 2008, there would be a linkage between the two indices of price levels. This broke down during this crisis.

 

Raghuram Rajan’s policy of delinking WPI from inflation set in motion a process of consequences that would deter investment. While the CPI remained relatively higher, the benchmark repo rates were set towards the CPI. Thus the real repo would be the nominal repo minus the CPI growth rate. Yet, as mentioned above, the corporates would link their investment real interest rate to WPI. Therefore, the outcome was the real rates went up. While real repo in terms of CPI remained in the acceptable ranges, it was the WPI based real rates which touched over 4% at times between 2017 and 2019. This led to a drop in investment. There are many economists who believe that the India growth rate suffered and dropped down primarily because of the high real rates. As one is aware, there exists a negative correlation between investment and real interest rates.

 

While inflation might have remained under control, the high real rates pushed the GDP growth rates downwards. However, as some economists point out, the inflation did not come under control because of the RBI policy, the inflation remained muted across the world including the advanced economies. This came about for host of reasons and not merely due to the RBI policy. The RBI policy, in the views of these economists, all it did was to reduce the growth rate. The inflation would have remained in southward direction for fairly long period time irrespective of the targeting. In fact, the inflation remained quite low in the early 2000s which also saw a significant growth rate in the economy. There was no inflation targeting as the objective. In fact, inflation targeting emerged at an informal level in the early 2010s, when the government abdicated its policy to control inflation to the RBI. Yet, the real rates had remained low during the period where inflation came closer to the double digit mark.

 

As the RBI reviews it position, there would be quite a few imponderables at play. There would be an argument of doing away with the inflation targeting. As the pandemic economy has shown, it is the fiscal space that has kept the economies afloat rather than the monetary policy. As the new data seems to be pointing out, inflation is no longer the elephant in the room and in fact seems to be hovering in the minds of the policymakers only because of past experiences. The ghosts of 1973 hover around many an economists even today across the world. The policy of inflation targeting arose in this context across the world. Yet, there is little evidence of 1973 playing out. In fact it was specific circumstances, partly geopolitical that drove the crisis and the inflation rather than any economic happenstance.  While the abolitionists would have a field case, those in advocacy of inflation targeting would want to give it an extended run before passing any judgment. It has been around five years since the adoption of the policy and they prefer an extension before a review is taken up. There is a strong case for changing the terms of reference. The inflation rate in India has remained within the bounds but the GDP growth has declined. Therefore, it might be prudent of linking the inflation targeting to GDP growth rather than a stand-alone proposition. There is also a need to link real repo with corporate borrowings rather than consumer borrowings. The RBI has to take a review and one that is emerging out clearly that the policy on a stand-alone basis as practiced in the current form needs refinement with the learning curve accumulated over the last five years.