We have not moved to inflation targeting as yet, says Raghuram Rajan

24 March, 2014

Macro Economics; Central Bank; Economic Indicator; Inflation And Deflation

Dr. Rajan said that "probably we should focus more on CPI than wholesale price index (WPI)

because CPI is what actually the common man sees and based on many decisions including

wage decisions".

The Reserve Bank of India (RBI) Governor Raghuram Rajan on Friday said that the central bank was

yet to take a decision on Urjit Patel committee report which had suggested an inflation target and was

still in discussion with the government on the subject.

“We haven’t moved to inflation targeting as yet,” said Dr. Rajan while addressing the convocation

ceremony of the Indira Gandhi Institute of Development Research, here.

The Deputy Governor of the RBI Urjit Patel had submitted, in January last, a report of the expert

committee to revise and strengthen the monetary policy framework, suggesting the central bank to move to an inflation target, with an aim to eventually bring down consumer price index (CPI)

inflation to 4 per cent with a 2 per cent band on either side.

“There is something that the Urjit Patel Committee suggests but that is not something which the RBI

has accepted. We are exploring the recommendations of the committee report and there are some

aspects of it, which has to be discussed with the government.......including setting up of a Monetary

Policy Committee and what is the target (inflation) would be,” said Dr. Rajan.

However, reiterating his preference for CPI, Dr. Rajan said that “probably we should focus more on

CPI than wholesale price index (WPI) because CPI is what actually the common man sees and based

on many decisions including wage decisions”.

Further, he said that there was a need to bring down CPI and a reasonable path to bring it down

overtime — whatever level it ultimately comes down to. “A path to bring it down is 8 per cent by the

end of this year and 6 per cent at the end of two years,” he added.

Dr. Rajan also felt that, across the world, it had been experienced that allowing inflation to rise does

have costs and does not have benefits. He warned “Higher and higher level of inflation feed on each

other and the ultimate is hyper inflation. Hyper inflation has social conflict because middle-class savings get wiped out. Hyper inflation is not where we want to go. Moderate rate of inflation do not

necessarily translate into hyper inflation, but we need to be careful”.

Keywords: Raghuram Rajan, RBI, inflation control measures, CPI, WPI, hyper inflation

UNDERSTANDING INFLATION TARGETING

By:C. Rangarajan 8th December, 2014

Economy, Business and Finance; Economy (General); Macro Economics; Finance (General); Money and Monetary Policy; Macro Economics; Central Bank

Inflation targeting re-emphasises the primacy of price stability as the objective of monetary

policy. Given the rigidities in the economy and lags in policy impact, it must be operated with

flexibility

Inflation targeting is back in the news and this is welcome. I have always held the view that the

dominant objective of monetary policy is the maintenance of price stability. Inflation targeting gives

precision to the concept of price stability.

In any monetary policy framework, a key ingredient is an enunciation of its objectives. This aspect has assumed increased significance in the context of the stress being laid on the autonomy of central

banks. Autonomy goes with accountability, and accountability in turn requires a clear statement of

goals.

The case of price stability as the major objective of economic policy rests on the assumption that

volatility in prices creates uncertainties in decision-making. Rising prices adversely affect savings while making speculative investments more attractive. These apart, there is a crucial social dimension,

particularly in developing countries. Inflation adversely affects those who have no hedges against it,

and this includes all poorer sections of the community. This is indeed a very strong argument in

favour of the maintenance of price stability in emerging economies.

“Apart from monetary policy, regulation of the financial system, particularly the

banking system, is entrusted to central banks in most countries. There has to be close

coordination between these two functions.”

Price stability and growth

A crucial question that arises in this context is whether the pursuit of the objective of price stability by monetary authorities undermines the ability of the economy to attain other objectives such as growth.

In short, the question is whether there is a trade-off between inflation and growth. There is a general

consensus that over the medium and the long term, there is no such trade-off and an environment of low inflation is most conducive to faster economic growth. However, there could be such a possibility

in the short term. By injecting greater demand and thereby generating higher inflation, higher growth

may be achieved. However, to sustain this growth, the authorities may have to generate higher and

higher inflation. This will end up as a self-defeating exercise.

What then is the tolerable level of inflation? At very low levels of inflation, there may not be any adverse consequences on the economy. However, in every economy, given its structure, there is

always a certain level of inflation beyond which costs of inflation begin to rise steeply. It is this

inflation threshold which can provide guidance to policymakers. Interestingly, the Chakravarty Committee, of which I was a member, regarded the acceptable rise in prices as 4 per cent. Several

studies in the Indian context have estimated that the threshold level of inflation may be around 6 per

cent.

Other objectives Questions have been raised about the robustness of such models. Even large econometric models are

not in a position to capture all the costs of inflation. This order of inflation is however higher than

what developed countries normally aim for. This will have some implications for the exchange rate of

the currency and Current Account Deficit. In the Indian context, it is best to work towards an average of 4 per cent and take strong action if it touches 6 per cent. This will amount to inflation targeting

with a band, as recommended by the Urjit Patel Committee. Such a commitment will also dampen

inflation expectations.

Does the focus on inflation targeting by monetary authorities mean a neglect of other objectives such as growth and financial stability? Hardly so. What inflation targeting demands is that when inflation

exceeds the threshold level, the primary focus of monetary policy must be to bring it back to the

desired level. It is sometimes claimed that the financial crisis of 2008 in the United States and western Europe sounded the death knell for inflation targeting. There is continuing debate on whether the

crisis was precipitated by monetary policy failure or regulatory failure. Countries like Canada and

Australia, which were committed to inflation targeting, were not caught in the crisis.

Central banks have multiple functions. Apart from monetary policy, regulation of the financial

system, particularly the banking system, is entrusted to central banks in most countries. There has to be close coordination between these two functions. For the crisis itself, regulatory lapses have to take

major responsibility while monetary policy in these countries might at best have played a facilitating

role. The low interest rate regime which prevailed because of low inflation could have created an environment favourable for high risk-taking. A rise in asset prices should have alerted the monetary

authorities and they should have taken appropriate action. Inflation targeting does not preclude other

objectives from the purview of monetary authorities so long as inflation remains within the comfort

zone. The control of inflation becomes its exclusive concern only when inflation crosses the

acceptable level.

Can it be done?

Can the Reserve Bank of India (RBI) or for that matter any central bank effectively implement an inflation mandate? Do they have enough instruments to achieve the goal? The ability of the central

banks to control inflation when such inflation stems from excess demand is normally conceded. It is

when inflation is triggered by supply shocks that some doubts are raised. Such supply shocks are most

common in countries like India where agricultural production is subject to the vagaries of nature. Even when inflation is triggered by food inflation, monetary policy and fiscal policy have a role to

play. If food inflation lasts long, it gets generalised. Wages rise leading to a general cost push

inflation. If head line inflation exceeds the acceptable level, monetary policy must act at least to ensure that the return on financial assets is positive in real terms. In a situation of supply shocks, it

may take longer for monetary policy to bring down inflation. The recent experience with inflation in

our country is a good example of this. That is why the inflation mandate must provide for a range and a time frame for adjustment which should not be too short. Nevertheless, monetary policy must act

irrespective of what triggered inflation. Obviously, supply side management is needed in situations of

supply stock and that should be the responsibility of the government.

Institutional framework The appropriate institutional framework for implementing the inflation mandate also raises certain

questions. The first issue is on who should determine the acceptable level of inflation. In most

countries which have adopted inflation targeting, the target is set by the government or Parliament. This appears to be appropriate in as much as the acceptable level of inflation is not purely an

economic issue. However, once a mandate is prescribed by the government or Parliament, the

monetary authority should be left with full autonomy to use whatever instruments that are available to

it to implement the mandate.

The second issue relates to an appropriate price index which should be used to monitor inflation. In India, we have monitored inflation by mostly looking at the wholesale price index. That was because

of the easy availability of this index. Until recently, we have had no composite retail price index.

Since the objective of inflation targeting is to minimise the impact of price rise on people, the

appropriate index will be retail inflation.

The third issue relates to institutional arrangements within the monetary authority to take policy decisions consistent with an inflation mandate. In several countries, a technical monetary policy

committee is constituted with members drawn from the central bank, from the government and from

outside experts. My preference would be to constitute a committee of the board of the RBI to do this. This is what was done when the Board for Financial Supervision was set up. While constituting the

central board of the RBI, this aspect of the work of the bank must also be kept in view.

Inflation targeting re-emphasises the primacy of price stability as the objective of monetary policy.

Given the rigidities in the economy and the lags in policy impact, it must be operated with flexibility.

(Dr. C. Rangarajan is former Governor of the Reserve Bank of India.)

RBI and inflation targeting: who is to bell the cat?

C. R. L. Narasimhan

14th December, 2014

Macro Economics; Central Bank; Inflation and Deflation

A fundamental question is whether inflation targeting should be the cause for crimping well-

earned central bank autonomy.

Inflation targeting is back in the news. Simply put, it means entrusting the central bank of the country

— the Reserve Bank of India in this case — the job of maintaining price stability. In practice, the RBI

would be called upon to maintain inflation within a pre-determined, well publicised range. Other

objectives such as furthering growth obviously matter, but price stability will be the focus.

The government has an important role in inflation management. While the monetary policy’s role in

combating inflation is well recognised, it becomes far more difficult to demarcate the respective roles

of the government, and the RBI questions such as who will fix the inflation target and on what

anchors — reference points — will the exercise be based cannot be easily answered, ignoring

fundamental issues such as central bank autonomy.

Political dimensions will surface

It is inevitable that the political dimensions — the relationship between the Finance Minister and the

RBI Governor — will surface. In fact, at the time of the recent RBI monetary policy statement, an

undercurrent of differences between the two on whether there should be a rate cut or not is perceived

(whether true or not).

Growth versus inflation control has been a traditional monetary policy dilemma, and it so happens

that at the present juncture, the RBI is seen to be firmly focussed on inflation even ignoring — as its

critics say — the requirements of the real economy. Inflation targeting has become highly topical after

the RBI-appointed Urjit Patel committee submitted its report in January. In its key recommendations,

the panel recommended inflation targeting to be formally accepted. In India, the Consumer Price

Index-based inflation (retail inflation) will replace the Wholesale Price Index-based inflation as the

policy anchor. The monetary policy committee will be given the mandate to maintain the level around

a specific range. The RBI will be accountable for achieving this. While some parts of the Patel

committee report have been accepted — the CPI inflation has become the policy anchor — there is a

lot of controversy on who would fix the inflation target. Should the RBI be given complete freedom to

fix and achieve the target? In which case what role does the government have?

Even before the report’s key recommendations were accepted, the RBI has gone ahead and fixed the

target range for inflation — 8 per cent by January, 2015, and 6 per cent by January, 2016. The

eventual target will be plus/minus 4 per cent. Significantly even though retail inflation has fallen

sharply, the RBI has not budged from its position of a no interest rate cut. In September, retail

inflation came down to its lowest since the composite Consumer Price Index was constituted in

January, 2012. Falling food prices were mainly responsible. Yet, the RBI persevering with the status

quo is to be seen in the context of possible supply-side shocks and food prices shooting up again due

to poor monsoons.

Government’s misgivings

The government has not been happy with the thrust of the Patel committee’s recommendations. Back

in January when the report was published, a senior government spokesperson had expressed

displeasure over some key recommendations. For instance, targeting CPI inflation would mean higher

policy rates for a longer period (this, of course, was much before the fall). Further, the CPI is

imperfect. The large weightage given to food items would mean that structural and supply side issues

need to be addressed. These are not usually dealt with by monetary policy.

In reply to this, the argument is that the RBI has an important role. Well entrenched inflation

expectations may lead to higher wage settlements causing demand side pressures. Arguably, the most

contentious point is in the composition of the monetary policy committee, which will (among others)

be the focal point in the battle against inflation.

Hitherto, it has been the Governor who determines the rates after considering the views of the central

bank’s technical committee. The Patel panel proposed a monetary policy committee (MPC) with three

internal members — the Governor, the Deputy Governor and the executive director in-charge of

monetary policy as well as two full-time members to be appointed by the RBI. If the committee had

its way, the RBI’s control over monetary policy would be total. Not surprisingly, it is this last point

which is at the crux of differences between the government and the RBI.

New equations

Unconfirmed reports speak of Finance Minister Arun Jaitley deciding on an eight-member MPC with

five external members, whose names would be cleared by the RBI. Most importantly, the inflation

target will be set by the government or be cleared by it. All these would mean reduced autonomy for

the RBI. The desirability of these moves would depend on the new equations that will come about

between the Finance Minister and the RBI Governor.

So far, the NDA government has been extremely circumspect in voicing its opinions on things such as

rate cuts. This has been in sharp contrast to the UPA period. A fundamental question is whether

inflation targeting — vital as it is — should be the cause for crimping a well- earned central bank

autonomy. The point also needs to be made that given the onerous nature of the task of maintaining

price stability and the huge responsibility cast on whoever is going to fix the target rate, should the

RBI take on the role enthusiastically? Elections have been lost in the wake of a price rise.

Keywords: Reserve Bank of India, inflation targeting, relationship between the Finance Minister and

RBI Governor