Who Needs Inflation Targeting?
Op-ed in the Business Standard, New Delhi
© Business Standard
In India's six-decade economic history, the list of policy successes is short. Take out the successes induced by crises and those stemming from inadvertent inattention (for example, the "failure" to regulate the information technology sector), and the list of successes by design shrinks even further. But the one prominent item on this list must be India's management of inflation and the exchange rate, a considerable achievement given that moderate inflation was achieved in the face of three decades of fiscal laxity. And yet, today, there is a growing clamor to fix this system. It ain't broke but we still want to fix this rare success.
The fix is inflation targeting (IT), but it is both unnecessary and inappropriate for India in the foreseeable future.
Start first with the unnecessary. Milton Friedman, who famously described inflation as always and everywhere a monetary phenomenon, distinguished the proximate cause of inflation (excessive increase in money supply) from the deeper social causes. Inflation has efficiency consequences but it arguably has greater distributional ones. It transfers income to the rich and those with financial assets and away from fixed-income earners and the poor, who are less able to protect themselves against inflation. Hence the characterization of inflation as a tax on the poor.
India does not need the institutional fix of inflation targeting to keep inflation low because there is a strong societal consensus in favor of low inflation.
But the remarkable and puzzling contrast is this: India has had a pretty undistinguished record on providing essential public goods and services (health, education, water, and power) for the poor, but its record on delivering low inflation-a public good of special importance to the poor-has been exemplary.
Not just recent events, not just the events of last year, not just the price-of-onion electoral debacle of the Bharatiya Janata Party (BJP) government a decade ago, but consistently over time, the panic that seizes Indian politicians of all stripes when inflation exceeds 5 percent is testament to low inflation being deeply etched in the collective Indian DNA. In this sense, India is not unlike Germany, where the Weimar hyperinflation of the interwar years left such a scar that German society has subsequently never tolerated high inflation. Germany had low inflation not because of the Bundesbank; it had an inflation hawk of a Bundesbank (a trait transferred to its successor, the European Central Bank) because German society would tolerate nothing else.
India does not need the institutional fix of IT to keep inflation low because there is a strong societal consensus in favor of low inflation. With some exaggeration, India might even claim that it already has the mother of all inflation targeting regimes.
Turn next to why IT might not be appropriate. The argument relates both to objectives and instruments. Should the Reserve Bank of India (RBI) have an inflation target as its exclusive objective? In a world of full capital mobility, it is true that an inflation target and an exchange rate might not always be compatible. But we are not there yet in terms of full capital mobility, we are sensibly not hurrying to get there, and during the valuable interim a competitive exchange rate is a desirable target of policy, as Shankar Acharya also noted recently. To rule that out in advance seems very costly, especially since the gains from a competitive exchange rate can be quite substantial as the Chinese experience and broader empirical research demonstrate. Inflation cannot be the jealous god at whose altar monetary policy must genuflect.
To be sure, there will be periods where the exchange rate and inflation targets will conflict, but there cannot be much doubt about the hierarchy in the Indian case-conquering inflation will rule. But in other times, the RBI can also profitably and effectively target the exchange rate as it has demonstrated without sacrificing inflation.
Are there not costs of creating multiple targets? Won't the consequential monetary policy send confusing signals? Not really. The Indian political experience should make clear to market participants that the low inflation objective will never be seriously sacrificed. And to the extent there is some irreducible uncertainty, that is a small cost to pay for pursuing more than one objective.
Turn next to instruments. Inflation targeting assumes that (i) the instruments available to the RBI are effective in combating inflation and (ii) that all the instruments available to combat inflation are with the RBI. Both, especially the latter, are questionable.
There is a well-rehearsed debate in India on the effectiveness of the monetary policy instruments especially when the shocks are on the supply side either from domestic agriculture or from abroad. The truth probably lies somewhere between the polar views of total ineffectiveness of policy and total effectiveness. The former cannot be true because exchange rate appreciation (a dimension of monetary policy) can moderate the effect of foreign supply shocks, and, in any case, tighter monetary policy can dampen the second round effects of price shocks and prevent inflationary expectations from getting entrenched. But equally the latter cannot be true either because persistent supply-side shocks can attenuate monetary policy's effectiveness.
But the bigger problem is the assumption that the RBI will have all the instruments to combat inflation. Precisely for the reason that inflation is a sensitive political issue, inflation threats, especially serious ones, will spur action by the government, which will seek to deploy all available instruments to ward off the threats. It is politically unrealistic to think that an IT regime will allow future governments to sit back and leave it to the RBI to address inflationary problems with the relatively limited set of instruments at its disposal.
In the current crisis, for example, the government went into emergency mode and responded by using nonmonetary instruments. Although the government response is best characterized as an exchange rate appreciation, it was appreciation in the food sector achieved through the trade policy route of liberalizing imports and protecting exports (a case of reverse mercantilism). But the broader point is this: Given the critical importance of keeping inflation low, governments will always reach in for the full arsenal, monetary and nonmonetary, of instruments and will meddle in combating inflation, never completely ceding the task to the RBI.
In sum, therefore, inflation targeting seems to be an unnecessary and inappropriate solution in search of a nonexistent problem. Can we move on to finding creative solutions for the real problems?