Factors that show RBI can do better than inflation targeting

Most observers expect RBI’s Monetary Policy Committee (MPC), which will begin its bimonthly meeting on August 3, to hike interest rates once again. The justification for this comes from the inflation targeting (IT) framework which is the guiding principle of India’s monetary policy.

Most observers expect RBI’s Monetary Policy Committee (MPC), which will begin its bimonthly meeting on August 3, to hike interest rates once again. The justification for this comes from the inflation targeting (IT) framework which is the guiding principle of India’s monetary policy. Simply speaking, the IT framework, an idea which has worldwide acceptance, assumes that the central bank can maintain a fine balance between inflation and growth by using interest rates. Here are five charts which explain the limitations of this approach in the Indian context.

(REUTERS)

Does high growth mean high inflation in India?

The keystone of inflation targeting is a positive relation between inflation and activity, eventually resulting in what the economists call overheating. This is primarily on account of rising labour costs resulting from tighter labour markets. So, to control inflation, the central bank needs to squeeze the purchasing power of people (and corporations) through an increase in cost of loans.

Let us first scrutinise the positive relationship between the level of activity and inflation. In chart 1, we plot the monthly data of consumer price index-combined (CPI-C) inflation against the index of industrial production (IIP) for the period between April 2012 - May 2022 (it is not possible to go further back because the two series are not available). It is clear that, let alone a positive relation, there is hardly any relationship between the two (the line drawn in the chart plots the trend relationship between the two variables). This holds even if we remove the two outliers on activity associated with the lockdown (chart 1B). This simply means that a change in the level of activity has not really influenced CPI inflation since 2012. The reason is that in a labour surplus economy such as ours (with increasing labour contractualisation), labour markets do not necessarily get tighter, or at least, have not since 2012.

External factors such as crude oil prices are bigger drivers of inflation in India

It is quite likely that the prices may rise in tandem with a necessary commodity such as oil, especially in a heavily oil-importing country such as ours. In chart 2, we plot the CPI (and WPI) inflation against the crude prices. It is clear that the three (to be sure, WPI and crude more closely) have moved together in the recent period of high inflation.

As is obvious, RBI has no control whatsoever on crude oil prices. To be sure, the fiscal policy arm does play a role in deciding domestic fuel prices via the tax route. In fact, MPC, in its meeting more than a year back (Feb 5, 2021) argued that “(a)n unwinding of taxes on petroleum products by both the Centre and the states could ease the cost-push pressures”.

If inflation is driven more by other factors than economic activity, then a key premise of IT becomes unviable in the Indian economy.

What about the efficacy of IT in anchoring inflation expectations?

There is a last line of defence by IT supporters that RBI can at least “anchor” inflationary expectations by announcing targets in advance and acting aggressively to implement them. But this is also weak, especially since it is common knowledge that the key factors of inflation, such as crude prices, are beyond the control of RBI. The fact that RBI’s household inflation expectation survey showed a dip in inflation expectations after the government announced a cut in excise duty on petrol and diesel in May 2022 (three-month expectations fell from 10.8 to 8.9) underlines this argument.

The other danger of dogmatic inflation targeting

What is biggest pitfall of a monetary policy driven by an inflation targeting premise which does not hold (inflation being driven by exogenous factors rather than economic overheating)? It introduces an asymmetry in monetary policy’s impact on the economy; it cannot do good but can do a lot of harm. During periods of demand buoyancy (the 2000s), interest rate had no significant effect on the level of activity (see chart 4). But when the economy entered a slack phase (2010 onward), the asymmetry in interest rate and activity kicks in. While a fall in the interest rate does not necessarily revive the economy (see chart 4 during much of the pre-pandemic slowdown), a rise in interest rates (13 times between January 2010- December 2011) brought the activity precipitously down (chart 5) even as high WPI inflation stayed the same (a typical case of stagflation). While inflation targeting as a framework proper was introduced much later in India, 2010-11 is considered to be the period when it was piloted. Duvvuri Subbarao, the RBI governor of that time, writes in his book Who Moved my Interest Rate?, “bringing inflation down by raising interest rates understandably became my foremost priority and remained so for much of my term”.

Critiquing inflation targeting does not make monetary policy irrelevant

We would like to end with a rider. While we are effectively arguing against high interest rates, the pendulum should not swing in the other direction of very low rates either, particularly in the territory of zero or negative real rates. That may just generate bubbles of speculation with cheap credit finding its way into the stock market. As Keynes said famously: ”Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation”. So, if there is one role that RBI should take seriously, it is to keep a healthy balance between speculation and enterprise instead of focusing on something it cannot actually control.

*Rohit Azad and Indranil Chowdhury teach Economics at JNU and PGDAV College, DU respectively.