As the term of the original agreement between the Centre and the Reserve Bank of India (RBI) on inflation targeting ends on March 31, evaluations of this aspect of monetary policy have begun to emerge in the public domain. Two points have been made: first, that the inflation rate has remained within the prescribed band of 2% to 6% since 2016, when inflation targeting was introduced, and secondly that the RBI has succeeded in anchoring inflationary expectations. In fact, the lower inflation rate has been seen as the outcome of the latter. Our long-term research on inflation in India suggests that the evidence, however, is not conclusive on the efficacy claimed for inflation targeting.
Though macroeconomic policy may not be of wide interest, a rudimentary understanding of what is meant by inflation targeting may be useful. Inflation targeting is only one of a set of imagined inflation control policies. Globally, inflation control became de rigueur after the high inflation that followed the oil shock in the early 1970s. In fact, well before inflation targeting was advanced, Milton Friedman had brought inflation control to the centre stage through his relentless highlighting of the ever-lurking threat of inflation.
On the other hand, in India, policymakers had engaged with inflation since the 1950s, when plans to industrialise met the challenge of inflation. Thus, scepticism about inflation targeting as a strategy of inflation control does not imply that inflation control is not a legitimate objective of economic policy. While the monetarist Friedman had prescribed money-supply targeting as the means to control inflation, inflation targeting prescribes the use of the interest rate to target inflation. So, really, what is new about inflation targeting is only the instrument chosen, not the goal itself. There is, however, the vague suggestion that it is likely to be more effective than the monetarist approach, as the instrument, the policy interest rate, is under the direct control of the central bank.
However, what has remained hidden in public discourse is the economic model that underlies inflation targeting. This model revolves around the proposition that inflation reflects “overheating”, or economic activity at a level greater than the “natural” level of output, having been taken there by central banks that have kept interest rates too low, at a level lower than the “natural” rate of interest. From this follows the recommendation that the cure to inflation is to raise the rate of interest set by the central bank, the so-called policy rate, which in India is termed ‘repo’ rate. A feature of this theory of inflation is that its central construct, the natural level of output, is unobservable. This makes it next to impossible to verify the explanation, which is also self-referential. The exponent starts out by stating that the inflation rate is rising as the output is higher than its natural level, but when asked how it has been concluded that output is actually higher, the response is “for inflation is rising”. Understanding phenomena on the basis of faith is not scientific. Despite this logical vulnerability, inflation targeting is a reality in that it is the Centre’s stated policy of inflation control.
Our work demonstrates that the model that underlies inflation targeting is not statistically validated for Indian data. But instead of going into specifics, we scrutinise in this article whether recent history supports the claim that inflation targeting has been successful on the grounds that the inflation rate has remained within the band agreed to between the government and the RBI, and whether it has been achieved by “anchoring inflation expectations”.
Inflation in India entered the prescribed band of 2% to 6% two years before inflation targeting was adopted in 2016-17. In fact, inflation had fallen steadily since 2011-12, halving by 2015-16. This by itself suggests that there is a mechanism driving inflation other than what is imagined in inflation targeting.
The view is further strengthened by the finding that the decline in inflation over the five years concerned was led by the relative price of food. While falling food-price inflation per se does not rule out the possibility that expectations of inflation may have fallen in this period, it would be difficult to explain why expectations would have fallen so sharply even in the absence of inflation targeting, considered essential for anchoring expectations. Recall that the adoption of the policy in 2016 came after inflation had entered the prescribed band. RBI data on household expectations show them remaining well above 6% for twelve years up to 2020. Finally, it is the flaring up of both inflation and inflation expectations after March 2020, when the COVID-19 lockdown was announced, that makes it difficult to believe the thesis of an “overheating” economy. Why did expectations soar if they had been anchored through inflation targeting? On the other hand, we can explain the flaring up of inflation in terms of food prices, as supply chains were disrupted due to the lockdown.
In conclusion, for the sake of argument, let us assume that over the past five years, inflation in India has been controlled via inflation targeting. It may then be asked what the benefits of this have been. We can think of five variables of interest in this context, namely growth, private investment, exports, non-performing assets (NPAs) of commercial banks, and employment.
The economy’s trend rate of growth actually began to decline after 2010-11. So, inflation targeting could not have caused it, but it is of interest that sharply falling inflation could do nothing to revive growth, belying the proposition that low inflation is conducive to growth.
For investment, there is reason to believe that higher interest rates, the toolkit for inflation targeting, may have been harmful. The swing in the real interest rate of over 5 percentage points in 2013-14 was powered further in 2016, when inflation targeting was adopted, and could have contributed to a declining private investment rate. It is interesting that policy entrepreneurs assert that the benefits of low inflation may be considerable for private investment.
We need to say nothing about exports and employment, except that they had fared poorly since inflation targeting became official.
Finally, NPAs. It has long been recognised that a central bank focusing on inflation may lose control of financial stability. NPAs have grown since 2016, and the cases of IL&FS, PMC Bank, PNB and YES Bank suggest that poor management and malfeasance in the financial sector could escape scrutiny when the central bank hunkers down to inflation targeting.
We end with two points. Inflation control will always be relevant but there is no conclusive evidence that the policy has worked in India. Secondly, the presumed benefits of low inflation are yet to surface. So, we should guard against the possibility that inflation targeting may deliver the worst of all worlds, i.e., raising interest rates, with all negative consequences, without lowering inflation. Lastly, assuming that the decline in inflation in India is due to inflation targeting would stand in the way of acknowledging the source, the vagaries of the price of food.
Pulapre Balakrishnan is with Ashoka University, Sonipat and M. Parameswaran is with the Centre for Development Studies, Thiruvananthapuram