The Reserve Bank is off target

“Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.” These lines from John Maynard Keynes come to mind when observing the recent performance of the Reserve Bank of India (RBI) with respect to the conduct of monetary policy. Strenuous effort has been made to lead the citizen to believe that one of the many significant actions of the government of the day is to have moved monetary policy in India onto a “modern” plane. The centrepiece of this claim is that the central bank will now be judged entirely in terms of its record on inflation. That is, the RBI has been reconfigured as an ‘inflation-targeting’ central bank. As part of this arrangement, it has been set an inflation target of 4%. Then, somewhat counter-intuitively, it has been given leeway in the form of a band within which the inflation outcome may lie. This band is wide, ranging from 2% to 6%.

Missing the point

Since the move to inflation targeting, naturally, the RBI has been watched. In the early days it appeared to be coming out with flying colours with inflation not only well within the band but also declining. However, that the growth in the segment of the economy most directly under the control of the RBI, namely manufacturing, has been declining too has been noticed less. Under the new arrangement, the RBI cannot be held responsible for what happens to growth as it is to be judged entirely by what happens to inflation. But since June there is disruption and not in terms of the new vocabulary. Consumer price inflation has now declined to 1.5% in June; though only 0.5% below its lower bound, this inflation rate is far below the targeted 4%. Surely this is a case of missing one’s target by a long shot.

Rather than waste our time shaming the RBI, we should fruitfully engage with the idea of whether inflation targeting is the right way to tackle inflation in India. That central banks are unable to control the inflation rate is evident from the record of the Bank of England. One of the first central banks to shift to inflation targeting, and endowed with intellectual capital of the highest class, the ‘Old Lady of Threadneedle Street’ has a dismal record of achieving its inflation target. Why is this so? Is it that the bank was also trying to accommodate other economic variables such as employment or the exchange rate? While the latter is possible of course, it is highly unlikely, as no group of high-profile professionals would want to fail so publicly in their mandated task. The reason why they fail is because ‘inflation targeting’ is based on a poor understanding of inflation.

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A flawed model

The model underlying inflation targeting is that inflation reflects output being greater than the economy’s ‘potential’. The task now is to bring output back to its potential level via an interest rate hike. A problem with the model is that the potential level of output is unobservable. Moreover, the potential is believed to be subject to change by the proponents of the model themselves. To these infirmities, the response given is that it does not matter, as we need only observe inflation to conclude that there is an output gap. The problem with this form of reasoning is that it is self-referential. This may be demonstrated in the form of a conversation that proceeds as follows: “Why is the inflation rate rising?” “Because unemployment is below its natural rate.” “But how do you know?” “Because inflation is rising!” Here, ‘natural rate’ refers to the level of employment corresponding to potential output. It appears that under inflation targeting, the policymaker must proceed on faith. This is not a sound basis for governance.

Developing countries such as India have an economic structure different from the developed ones of the West for which inflation targeting was first devised. An aspect of this is that agricultural production is subject to fluctuation, and along with this the prices of agricultural goods. Now, when the relative price of agricultural goods rises due to slower growth of agriculture, the inflation rate rises. Such an inflation has nothing to with an economy-wide imbalance gap as visualised in the ‘output gap model’ underlying inflation targeting. Under inflation targeting, the response to rising agricultural prices would be to raise the rate of interest. This may have some desirable impact on inflation but it can come only at the cost of output loss in the non-agricultural sector. The output loss can only be rationalised as necessary by holding on to the assertion that inflation reflects actual output being greater than potential. But note that the whole process has been set off by a slowing of agricultural output. Now, the only way the output gap model can retain some traction in the context is by asserting that along with the reduction in agricultural output growth, the potential output is growing at an even slower rate. This is completely ad hoc and without a scientific basis.

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Role of agriculture

The role of agricultural prices in driving inflation in India is evident presently. Though the overall consumer price index is rising at 1.5%, that for agricultural commodities is actually falling, reflecting the fall in the relative price of agricultural goods we have referred to. Thus the RBI may have just got lucky over the recent past that commodity prices, which include domestically produced agricultural goods and imported oil, have grown at a slower pace. So, it is not at all clear that even when the inflation rate was within the band, it was the RBI’s handiwork rather than the hand of the weather gods in evidence. Champions of inflation targeting, observing the current decline in the inflation rate in India, are quick to claim victory for the RBI in terms of having anchored inflationary expectations, a claim for which the slightest evidence is given. It is to be recognised that even though the RBI cannot directly move agricultural prices, its response to their movement matters. As agricultural price inflation continues to fall, driving down the overall inflation rate, the real rate of interest rises. If the central bank does not respond by lowering the policy rate the real rate of interest will continue to rise, with negative consequences for non-agricultural output. This is exactly what we observe happening of late. We want to avoid a deflationary spiral.

To end with some exegesis. So, who in the case of our ‘modern’ monetary policy might be the “defunct” economist of the quote we started out with? It is Milton Friedman who asserted — without argument, it may be noted — that inflation reflects an output gap. The idea itself he borrowed from the nineteenth century economist Knut Wicksell. Friedman had recommended money supply control, a policy aggressively adopted by Margaret Thatcher in England but also in most parts of the West. When this policy failed, it was replaced by ‘inflation targeting’. This choice of terminology was truly inspired, for its very use conveys the resolve of actually trying to do something about inflation. But it is also tendentious, bearing the suggestion that there is no other method of inflation control. Whatever you may say about Friedman, he was not a slouch when it came to inflation. Back in India, with the RBI off target by a wide margin, we can see that inflation targeting is not what it is cracked up to be. Inflation control here requires supply management. This is not rocket science. 


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Pulapre Balakrishnan is an economist