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What role for inflation targeting?

Should inflation targeting or multiple objective targeting be the concern of only the monetary authorities? More often than not, monetary policy by itself cannot be effective, however well formulated it is, unless it is supported by fiscal policy, says A. Vasudevan.

THE INFLATION rate based on the increase in the wholesale price index for "all commodities'' has recently crossed the 4 per cent mark on a year-on-year basis. This may not turn out to be a matter of immediate concern because of the presence of a large pile-up of foodgrains. But this raises a larger question. Should the Reserve Bank of India shift its stance to strongly take measures to keep prices from further increases?

For many Indian economists, the central bank should, in fact, have a target of inflation, preferably announced, as the only objective of its policy. For them, from low inflation follows higher growth. Low inflation also stabilises investors' expectations and raises incentives to invest in activities that provide positive real rates of return. The incentives to provide wrong or asymmetrical information will be minimised. This will help reduce possibilities of making wrong (adverse) selection of investible projects on the part of lenders. This would imply that the elements that form the core of financial instability would disintegrate.

Not all the above claims of inflation targeters have been well tested. There is however good enough evidence to suggest that low inflation and relatively high growth have gone together in many countries. In fact some economists have suggested that for every country one could work out a threshold level at which growth could be maximised. The threshold, however, could be lowered over time depending on the technological breakthroughs in production processes. In other words, if productivity goes up, the threshold would come down. This in fact has been the story in most industrialised economies since the mid-1980s. Many developing countries that have adopted the advanced technologies have benefited in terms of low trends in inflation and movement on to higher growth paths.

Services, assets in

index basket

A number of questions however arise as commodity production in national output has over time lost out to the services sector that has been recording higher shares. This implies that inflation should be viewed not merely in terms of commodity prices but also the prices of services that most consumers absorb in their daily lives. If this is true, consumer prices based on a better basket of goods and services on a more frequent basis would have to be worked out, not the wholesale prices of commodities.

The prices that ordinary households pay for education and medical services, for example would have to be taken into account. Besides, there is wide concern over the movement of asset prices as they indicate future inflation trends. As financial markets spread, and as lending operations are based on collateral values of assets, it would become important to reckon asset prices. After all the real estate crash in Thailand in 1997 led to failures of many financial companies that in turn weakened the loan portfolio strength of many banks that lent to the financial companies. This sowed the seeds of financial instability in that country.

U.S., Japanese practices

Very few central banks have been mandated to pursue only inflation targeting as their goal in spite of a large influential opinion in its favour. The Federal Reserve in the U.S. has dual objectives relating to price stability and employment generation. In India, the RBI is required to use its credit and currency system to the nation's advantage and to pursue monetary stability. It is possible under such a framework one could emphasise one of the objectives even while pursuing the other, depending on what is known as the economic cycle that is being experienced by the country in question.

This has been so in the U.S. where inflation control during the recent boom period was the dominant objective. Such an emphasis may not be openly articulated if the current deflationary expectations persist for a longer time. On the other hand, in Japan, in recent years, the inflation rate tended to be near zero and the growth rate insignificant. Besides, Japan suffers from weaknesses in its financial, more particularly the banking system. The Japanese experience has been an unresolved puzzle and has in general placed question marks on the pursuit of inflation targeting as the only policy objective.

In India, the secular inflation rate averaged 7-8 per cent and the growth rate was a little over 4 per cent. But the variability in inflation has been higher than that in growth. Given the wide income disparities and the overall low living standards, and the high proportion of non-performing assets of the financial system, the country has very little option except to take policy measures to reduce the inflation rate and its variability and promote activities that help place India on a higher growth trajectory.

Ideally, what is needed is a flexibly operated rule-based announced stance in favour of inflation target and growth pursuit towards its potential. Such a stance can be easily criticised as an oversimplified version of what economists call the Taylor rule but this is probably the practical thing to do. In fact, one could well argue that most central banks follow such a simplified version in one form or the other under different labels.

In its own way, the RBI has been pursuing such a course rather discreetly in the last four years or so. It will, however, gain attention and help improve reputation if research initiatives on inflation issues and potential growth are undertaken on a large scale with help, if required, from outside experts in the academic and government circles and intensified quickly. Such studies would need to be brought out for purposes of transparency and for avoiding policy surprises. The outcomes of such exercises could be incorporated, if need be, in the medium term policy stance. This would still leave flexibility to move within the framework on a year-to-year basis. Such a stance will help stabilise market expectations and provide credibility at home and abroad.

A still larger question prevails. Should inflation targeting or multiple objective targeting be the concern of only the monetary authorities? More often than not, monetary policy by itself cannot be effective, however well formulated it is, unless it is supported by fiscal policy.

In the present context, fiscal deficits will need to be reduced sharply to let the private sector take up additional investments and public expenditures rendered relatively productive. It is only under such a fiscal policy framework, monetary policy could pursue inflation control and growth objectives.

(The author is a former Executive Director, Reserve Bank of India, in charge of Research Department and currently Honorary Adviser. The views expressed here are his personal ones.)

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