Monetary Policy: The Cost Of Inflation Targeting

When India moved towards inflation targeting, with the charge being led by former governor Raghuram Rajan and his then deputy Urjit Patel, some of their predecessors cautioned against it.

Bimal Jalan, YV Reddy, Rakesh Mohan... all cautioned in various conversations that for an economy as diverse as India, a multi-indicator approach works well. Some like Jalan questioned what the committee will do if inflation spikes due to factors beyond the control of the RBI, at a time of weak growth.

At the time, however, the focus was on bringing greater predictability to inflation in India and greater accountability to the central.

And so, India adopted a flexible inflation targeting mandate of 4 (+/-2) percent and headline consumer price inflation was chosen as the nominal anchor.

The target was flexible and growth was not completely ignored.

“The objective of monetary policy framework is to primarily maintain price stability, while keeping in mind the objective of growth,” the final monetary policy agreement read.

But primacy was given to inflation.

The framework has brought greater predictability to inflation and interest rates in India. But in turn, it has reduced the flexibility that the central bank enjoyed for decades, where it would toggle with its priorities based on what it felt was the most pressing need for the economy at the time.

The committee cut its growth forecast to 5 percent. That is 240 basis points below its growth projection in February. It said that growth will be between 5.9-6.3 percent in the first half of FY21 – still below the 6.5-7 percent pegged as “potential growth” for India.

Yet, the committee was forced to pause in its interest rate cutting cycle.

The reason was inflation and the inflation targeting mandate given to the MPC.

The committee raised its inflation projection sharply to 5.1-4.7 percent for the second half of the year, even though Governor Das put the increase down to “transient” factors in the press conference that followed. Indeed, so far, inflation has been driven higher mostly by food prices while demand-driven core inflation has been well below 4 percent.

Governor Das emphasised in his comments that the pause was temporary but also said that the MPC’s “primary goal” is inflation targeting, albeit while keeping the objective of growth in mind.

Still, the MPC could have used the provision of the “flexible inflation target”, which actually allows for inflation to go up to even 6 percent for a period of time, with the eventual goal to bring it back to the mid-point of 4 percent.

The governor didn’t disagree that he had that flexibility but said the decision to pause now was also about “timing”. You can’t keep “mechanically” cutting rates, he said, adding that rate cuts have to be timed in a way that they are most effective.

There was another debate that had taken place when India was moving towards inflation targeting — on whether we should target core inflation or headline inflation.

Many believed that in a country like India, where food is a major part of the consumption basked, targeting headline inflation with monetary policy is imprudent. Some suggested core inflation as the appropriate target. However, the Urjit Patel committee, which reviewed the monetary policy framework, believed that higher food inflation leads to generalised inflation and hence headline inflation is the right target to pick.

When Governor Das addressed monetary policy press conference in February, he was asked about the then-prevailing gap between core inflation and headline inflation. At the time, core inflation was high and headline inflation was low. Economists did not think the timing was right for rate cuts. Das started cutting rates in February. When asked why he did that even though core inflation was high, Das said the committee had a mandate to target headline inflation.

In announcing a pause in rate cuts, even though core inflation is low, Das stuck to that statement and the letter of the mandate.

In sum, today’s decision, in many ways, is the cost to pay for the inflexibility even a flexible inflation target brings. The new framework may add accountability but it reduces flexibility and room for measured judgment.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.