India is the only large emerging market (EM) that doesn’t currently have a monetary policy framework. Other than China, which targets the exchange rate, all large EMs target inflation. This is one of the main reasons why India saw a rise in inflation after the global financial crisis, while other EMs experienced a downward pressure on prices. It is clear to students of monetary economics that an inflation-targeting framework is the way forward for India, which is opening up its capital account and moving towards a flexible exchange rate regime.
India has chosen these two corners of the trinity — and this allows it to have an independent monetary policy. The lack of a monetary policy framework is a recipe for high inflation, low growth and highly volatile business cycles. The Urjit Patel report to revise and strengthen the monetary policy framework has recommended that the RBI adopt flexible inflation targeting.
What are the main elements of inflation targeting? First, a monetary policy framework requires a defined nominal anchor. There are many factors that determine the relative price of any two goods, while the nominal anchor determines the general level of prices. So, for example, if there are only two goods in an economy, and one costs double the other, what determines whether the prices are Rs 10 and 20 or Rs 100 and 200? When economies started using paper money, it became possible to create an unlimited amount of money. But this could cause these prices to rise to Rs 1,000 and 2,000 or any other such combination.
When paper money was anchored to gold or silver, or, in some cases, to the sterling or dollar, this used to determine the general level of prices. However, when these systems ran into trouble, countries chose a general price level as the anchor, with some allowance for changes in relative prices. A small amount of growth in the general price level allows for smooth changes in relative prices. Thus, the price level and a small, specified increase in it became the nominal anchor. This was the inflation target.
Such an anchor incentivises households to save. It allows businesses to plan, knowing how their cost structure will evolve over the years. After 1990, inflation targeting was adopted by 34 countries. The OECD countries were among the first to adopt it and, after 2000, a number of emerging economies such as Brazil, Chile, Colombia, South Africa, Thailand, South Korea, Mexico, Peru, the Philippines, Indonesia, Turkey and many east European countries followed suit.
More recently, after the global financial crisis, even developing countries started adopting this framework. After 2008, we have seen countries like Georgia, Moldova, Albania, Botswana and, in 2011, Uganda adopt inflation targeting. The fruits of the framework have been enjoyed by emerging economies. While all EMs are suffering from a slowdown in demand, India is suffering from stagflation. None of the other large EMs is experiencing such high inflation. None of them has such unanchored inflationary expectations.
Some people suggest that GDP growth should serve as the nominal anchor. But this is not possible. If it were, several countries would have already targeted growth and become rich. Countries with the highest inflation, like Zimbabwe, would also have been the fastest growing ones. An inflation-targeting framework takes into account the effect of various demand and supply shocks on inflation, output and exchange rates, and accordingly forecasts inflation, which the central bank then tries to bring back to the target rate in the medium run. For those interested in the details, Rudrani Bhattacharya and I have a recent paper on how an inflation-targeting framework would work in India (goo.gl/UeCZFm).
The paper presents a typical forecasting and policy analysis model, which shows how an inflation-targeting framework takes into account various cyclical factors that impact aggregate demand and supply to forecast inflation. One of the main problems with the public discourse on inflation targeting is that it assumes inflation-targeting central banks only look at past inflation and adjust rates accordingly, rather than figuring out how demand, supply and expectations impact inflation. As the Urjit Patel report argues, while there is a tradeoff between inflation and growth in the short run, there is no tradeoff in the medium run, and cross-country evidence suggests that low and stable inflation is, in fact, better for growth. No country has given up on an inflation forecast in its monetary policy framework.
The proposed flexible inflation-targeting framework also takes into account the difficulties India faces due to high and volatile food prices. In other emerging economies also, food accounts for a high proportion of the consumption basket. The report argues for the consumer price index, of which food is a large component, to be used as the measure of the nominal anchor. A CPI inflation target of 4 per cent, which can be breached by 2 percentage points on either side, will allow the RBI not to respond if inflation is above 4 per cent but within the target band, as long as this is because of supply shocks that will not persist. With the inclusion of food inflation in the target, its spillover into non-food inflation will reduce, keeping overall CPI inflation in check even if there are spikes in food inflation.
However, it should be elected representatives, and not unelected central bankers, who decide what the nominal anchor and monetary policy framework should be. Once decided, the central bank should be given the power to pursue these objectives and it should be made accountable to the democratic representatives of the people. Eventually, in India too, as in most other countries, the monetary policy framework must be enshrined in law. This was also the opinion of the Financial Sector Legislative Reforms Commission. In the meanwhile, the proposed framework is a huge step forward. It is in accordance with the voluntary adoption of governance-enhancing principles that regulators are embracing till the Indian Financial Code is legislated upon.