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COMMENTARY

Inflation Targeting as Policy


Option for India
Evaluating the Risks
Renu Kohli

Inflation targeting may have its


benefits but the timing of Indias
ongoing transition to IT an
adverse domestic and global
macroeconomic context poses
significant risks to a successful
implementation. Moreover, the
evidence of IT having a positive
impact comes from the
pre-financial crisis era; more
recent studies of the emerging
market economies over a longer
period show the non-IT countries
growing faster than those which
have adopted IT.

Renu Kohli (renukohli@yahoo.com) is a New


Delhi-based macroeconomist; she currently
leads the financial globalisation research
project at NCAER as an external consultant.

10

1 Introduction

n January 2014, the Urjit Patel Committee report proposed a new framework for monetary policy flexible
inflation targeting (FIT). Several arguments were made in justification of a
change from the previous, multipleindicator1 based structure, chiefly in response to its perceived failure and credibility loss from the inability to control
elevated, persistent inflation for some
years (para II.17, p 9, Report of the Expert
Committee to Revise and Strengthen the
Monetary Policy Framework, Chairman:
Urjit Patel; hereafter has referred as
UPC). While a formal adoption of the new
framework is being discussed with the
government, the Reserve Bank of India
(RBI) has accepted one of its key recommendations, viz, shifting over to consumer price inflation (consumer price
index, CPI) as the clearly defined nominal
anchor and adoption of a two-year glide
path to prepare the initial conditions
ahead of formal adoption.
Inflation targeting (IT) as a macroeconomic policy tool is now more than
two decades old, with varied country experience. It is distinguished by an explicit central bank mandate to pursue
price stability as the primary monetary
policy objective and a high degree of operational autonomy; explicit quantitative
targets for inflation; central bank accountability for performance in achieving the
inflation objective mainly through hightransparency requirements for policy
strategy and implementation; and a policy
approach based on forward-looking assessment of inflation pressures, incorporating
a wide array of information (Roger 2010).
The central bank publicly announces a
projected, or target inflation rate and
then endeavours to guide actual inflation

towards that target, using the interest


rate tool. A nominal anchor variable
is required to tie down the price level
(Jahan 2012).
The framework works through a stable,
predictable link between the policy rate
and the inflation rate, with rule-based
monetary action (Taylor rule). Operationally though, IT works more as constrained
discretion as the precise numerical target
for inflation is achieved over the medium
term, allowing policy to respond to shortterm economic shocks, e g, smoothing
output. It is underpinned by Friedmans
(1956) insight that there is no long-run
trade-off between inflation and growth.
A short-run trade-off in which higher
growth can be obtained at the cost of
higher inflation may exist but the two
are independent in the long run; therefore, central banks should focus on what
they can influence, viz, inflation. Because a
short-term inflation-growth trade-off may
tempt a central bank to occasionally favour
growth (principle of dynamic inconsistency, Kydland and Prescott 1977), an IT
regime seeks institutional structures
binding central banks to commit to a low
inflation target acceptable to the public.
Once a belief that inflation will remain
low is established, public confidence
that the medium-run inflation outlook
will not change much even when shocks
occur, will follow. The thrust of the
framework is recognition of inconsistency
in the pursuit and achievement of multiple
goals, inflation and unemployment (or
growth) with only one instrument (interest
rate). The overriding emphasis upon price
stability makes it the primary objective of
monetary policy, while the weights on
growth are reduced. Thus growth and
employment matter in IT only to the
extent that a commitment to a mediumterm inflation objective remains credible.
Against this backdrop, Indias shift
to FIT has only just begun, i e, public
announcement of a two-year glide path
8% headline CPI inflation by January
2015 and 6% by January 2016 towards
a medium-term (4% 2 band) inflation
target. Correspondingly, the RBI adjusted
its policy (repo) rate to 8% in January
2014; currently, it is on course to achieve

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COMMENTARY

the January 2016 target (6%). The


government too has endorsed the new
framework; it is comfortable with the medium-term inflation target as reflected
from statements of the RBI governor and
the finance minister. Essential support
structures like legislative changes to make
price stability the primary goal of RBI,
performance accountability, operational
autonomy as well as supportive institutional structures required for successful
FIT are yet to follow. Hence, this article
will only evaluate the implications of an
increased inflation focus, the shift from
producer to consumer price inflation for
monetary policy setting, and the peculiarities of the structural, fiscal and institutional backgrounds. The stressed national
and global macroeconomic environments,
it is argued, make the shift to inflation
targeting a risky policy option.
2 Implications
Several analysts consider adoption of
inflation targeting as the most significant
reform of 2014. As with most reforms, the
macroeconomic setting matters insofar
as timing is often quite critical for acceptance and eventual success. For example,
a strong economic cycle characterised
by buoyant tax revenues, robust incomes
and profits, etc, facilitates reforms that
otherwise may be costly, including
politically so, simply because of the partial
shield it offers. The opposite is true in
hard times, which can complicate, slow
down, or even overturn the reform process
in extreme cases. On other occasions,
e g, a currency, banking or financial crisis,
reform is unavoidable, making irrelevant the macroeconomic context. We examine the implications of the early steps
towards inflation targeting in this light,
focusing upon some critical aspects.
Figure 1 and Table 1 provide a snapshot
macroeconomic profile at the time of
transition. At the eve of the shift, December 2013, consumer and producer (wholesale) price inflation were a respective
9.9% and 6.4% while real GDP growth
was 4.6% in October-December 2013.
Fiscal gaps were enlarged, while corresponding current account balances were
alarming in 2011-12 and 2012-13. The
exchange rate, after respective real and
nominal effective appreciations of 8.5%
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Figure 1: India Inflation and Interest Rates


12
Shift to inflation
targeting

CPI
10

Core CPI

8
Policy rate
6

4
WPI
10-year bond yield
2

1
1/2012
4/2012
7/2012
10/2012
1/2013
Source: CSO, RBI and authors calculations.

4/2013

and 2.9% in 2010-11, depreciated steadily


from 2011-12: an annual average of 6.6%,
10.4% and 7.7% in nominal effective
terms (36-currency, trade-based, 2004-05
base) in the three years to 2013-14, with
corresponding real effective depreciation of 2.1%, 4.3% and 2.2%.
In stock terms too, the external balance
sheet steadily (Table 1, Col 7) deteriorated
as short-term external debt rose fast,
foreign exchange reserves declined and
external vulnerability increased. At the
balance sheet level, firms and banks
were significantly stressed as observed
from high levels of non-performing and
restructured assets: in March 2013, 24.4%
of the total loan portfolio of scheduled
commercial banks was stressed, with
near-similar share (23.9%) in March 2014.
A fair interpretation then is of an economic cycle at its trough, high inflation,
internal and external imbalances that
combined towards steep, cumulative
exchange rate adjustments triggered by
sudden capital outflows in these years. It is
an open question whether inflation targeting responded to these developments
and bind macroeconomic policy discipline.
Finally, the global economic environment was, and continues to be adverse

7/2013

10/2013

1/2014

4/2014

7/2014

10/2014

and uncertain: World output growth has


trended around 3% annually from 2011,
with steady lowering of growth forecasts
each year; growth in merchandise trade
volumes plunged from 13.9% in 2010 to
5.4% in 2011, then more than halving
to 2.3% and 2.2% in 2012-13 and was
projected to be 3.1% in 2014; advanced
countries continue to flit between
monetary and fiscal policies by turn,
avoiding structural reforms; while China
is on a permanently slower growth path.
While the UPC extensively considered
inflation performance, a discussion of
macroeconomic settings and their bearing upon timing of the transition does
not figure in the report. It must also be
underlined that not one, but two structural changes have taken place with the
transition to FIT: One, price stability is
now the primary policy objective. Two,
the nominal monetary policy anchor is
consumer price inflation against producer
price inflation previously. What risks do
these changes pose? Some key aspects
are discussed here.
Output Sacrifice or Disinflation Costs:
The interplay between the two changes
imposed by the new monetary policy

Table 1: India Macroeconomic Profile

2008-09
2009-10
2010-11
2011-12
2012-13
2013-14

GDP
(in %)

Fiscal Deficit
(Centre) 1

Current
Account1

Inflation2

Interest
Rates3

6.7
8.6
8.9
6.7
4.5
4.7

6.0
6.5
4.8
5.7
4.9
4.6

-2.3
-2.8
-2.8
-4.2
-4.7
-1.7

8.3
10.9
12.1
8.9
9.7
10.1

8.0
4.9
5.5
7.6
8.1
8

Net
Net Intl
Forex
Capital ac1 Invt Position1 Reserves1

0.6
3.8
3.7
3.6
4.8
2.6

-5.1
-11.6
-12.8
-13.2
-17.3
-17.7

13.8
18.3
16.1
14.1
9.8
9.0

Import
Cover4

9.8
11.1
9.5
7.1
7
7.8

1 in per cent of GDP, 2 Average cosumer prices, 3 Repo rate, 4 in months.


Source: IMF, RBI and author's calculations.

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COMMENTARY

framework and the macroeconomic context noted above provides a perspective on


the possible output sacrifice associated
with these. Critically, the UPC was silent
and non-transparent about the output
costs of disinflation during the transition
(glide path) to the medium-term inflation target even as it revisited the choice of
nominal anchor; the institutional structure, operating framework and instruments of monetary policy; the impediments to its transmission as well as its
conduct in a globalised setting. Though it
stated that output sacrifice was balanced
vis--vis the speed of entrenchment
of credibility in policy commitment
(UPC: Para II.42, p 19) in computing the
glide path to the medium-term inflation target of 4% (2% band) in two
years time, it did not share the estimated declines in GDP en route.
Notwithstanding this gap, which precludes understanding of the precise output gap at the time of the shift, qualitative
losses can still reasonably be inferred.
Two distinct components of disinflation
costs can be identified. The first constituent arises from a general deflationary
bias due to increased inflation-focus. This
can be termed as temporary or cyclical
contraction in output in the normal
course of monetary policy transmission
as demand moderates in response. Output losses incurred from these forces are
recoverable with resumption of the usual
business cycle.
The second output loss component
occurs from the move to significantly
higher consumer price inflation as nominal
anchor from much-lower producer price
inflation. This constitutes a permanent
loss of output for it arises from a structural change causing a lasting increase in
the real cost of capital to which producer
firms must adjust over longer period. It
represents a permanent cost disadvantage
from an enduring interest rate shock
whose size is directly measurable: This
is equivalent to the consumer-producer
inflation gap, an average 419 bps in January 2012-November 2014 (Figure 1).
This loss of competitiveness, in conjunction with existing cost disadvantages
like poor, inadequate infrastructures,
etc, comes at a critically low point of the
economic cycle when firms are at their
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most vulnerable with limited abilities to


withstand a shock of this nature. The
real output effects will play out and
manifest over a longer period, i e, beyond
the business cycle, making visible the
resultant, permanent decline in GDP as
some real investment reallocates; for
example, firms at the margins may altogether be priced out and transfer resources to where relative returns may be
higher. Given the larger significance of
cost of capital for manufacturing or the
tradable sector, the risk here is of
a resource-shift towards non-tradables,
which would undermine the intended
direction of structural adjustments to
bring about lasting corrections in the
current economic imbalances.
Balance Sheet Distress
The relevance of the macroeconomic
context for these transitions becomes more
apparent when we look at the severity of
the balance sheet distress that the extraordinary monetary tightening has no
doubt compounded, e g, stressed advances
have risen further to 24.2% of overall
loans by June 2014. Further, manufacturing growth in April-October 2014 was
just 0.7% over a comparable -0.1% contraction in 2013; bank credit (non-food)
growth of 4.3% in March-November 2014
was nearly half of 2013 is corresponding
7.2%; and the cumulative 75 bps of monetary tightening in September 2013-January 2014 all but failed to transmit to
banks who did not respond to monetary
policy signals in this period and are lowering deposit rates in recent months as
loan demand remains very weak.
For manufacturing firms to recover from
cyclical and structural shocks of this nature could take very long, especially in
an environment of surplus global capacity
across countries. An alternate setting for
choice of timing this transition could
have been (i) a stronger growth cycle,
not necessarily at the peak, but perhaps
in the upper region of an upswing; and
(ii) reduced consumer-producer price
divergence to minimise the size of interest
rate shock. If disinflation extracts too
high a price, the severe output losses in
the initial stages of inflation targeting
could increase risks to the next stages of
implementation itself as reasoned below.

Supply Side Risks: The Indian political


economy context, which must adapt itself
for monetary policy support, is essentially
non-responsive in that reforms of market
structures to allow free, efficient functioning and pricing to balance demandsupply forces have long been half-hearted,
delayed and interminably postponed.
This raises the risk of an extraordinary
burden upon monetary policy, which
could be forced to remain tighter than
otherwise would be the case. For, with
headline CPI inflation as nominal anchor,
food inflation is now subsumed under
this. As food inflation directly spills over
into a generalised price increase or core
inflation, to which the policy rate is
aligned, aggregate demand would have
to be kept sufficiently compressed until
some such time that quicker supply reactions set in. If supply-side responses are
unforthcoming, in conjunction with the
low-growth conditions at the time
of transition, the economy could be
trapped into a vicious circle, breaking
out from which could be difficult due to
a fear of undermining policy credibility.
Such a flexible supply response scenario
is presently hard to contemplate in the
political economy structure. It could of
course also be the case that inflation
targeting, which ties down monetary
policy to a certain path failing which
credibility is at risk could itself compel
such supply-side reforms.
Weak Institutional Framework: A
strong institutional support is essential
for inflation targeting. The most fundamental of this is fiscal support as fiscal
policy, due to its close and immediate
relationship with aggregate demand, can
negate monetary policy effort and potentially undermine the most credible of
central banks. The risk is especially large
in emerging market economies (EMEs)
including India, as fiscal dominance is
very often a key inflation driver. The
UPC well recognised this, dwelling at
large on the fiscal influences upon monetary policy conduct in India (Chapter 2,
Section 3). Recent fiscal history is quite
discouraging in this context. Adherence
to fiscal rules, critical for transparency,
accountability and forward-looking monetary policy, is not well entrenched.

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Indeed, the fiscal past is ridden by abandonment or pause of rules each time the
business cycle wanes, growth slows and
revenues decline. For instance, a pause
was announced in 2009-10 to combat
the crisis shock and return to the path
laid out under the Fiscal Responsibility
and Budget Management Act was delayed.
A new fiscal consolidation path was
drawn by the Kelkar panel in late-2012
to restore the health of public balances
by 2016-17; this was adopted with the
government on course to achieve this
since last quarter of 2012.
However, history seems set for repetition once more with the current public
discourse favouring a pause to the revised
fiscal consolidation path for accommodating growth concerns: With growth
recovery elusive, there is emerging consensus and advocacy for fiscal pumppriming: the governments recent MidTerm Review suggests that public expenditure replace the private business spending vacuum and kick-start growth; and
there is indication that the ongoing fiscal
consolidation road map may be revised,
modified or replaced to incorporate
countercyclical elements. The risk from
such political responses to the business
cycle in undermining the RBIs credibility
as also of the new framework is quite high.
Then again, while institutional support
by way of tight fiscal rules would be required in the next stages of FIT, the required fiscal path could be quite demanding given current growth conditions and
medium-term outlook. This directly
brings into focus the macroeconomic
timing of the transition. Unless growth
picks up quite substantially to relieve the
fiscal burden and relaxes budgetary constraints, there could be political temptation to delay or breach fiscal targets; or
political support for FIT could be weak.
Exchange Rate Fluctuations and the
Nominal Anchor: Exchange rate stability
is a key element in stabilising CPI inflation,
particularly in EMEs. Exchange rate fluctuations cannot be altogether ignored,
especially depreciations that lead to a
rise in inflation from pass-through of
higher import prices and greater export
demand, besides detrimental effects of
dollarised liabilities and vulnerability of
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access to international capital markets


which endangers financial stability
(Mishkin 2004). Inflation targeting is
theoretically inconsistent with reserve
accumulation as systematic monetary
policy responses to dampen exchange
rate fluctuations are incompatible with
price-level stability (Obstfeld 2013). The
open economy trilemma in macroeconomics proposes a corner solution of full
exchange rate flexibility to allow for
capital mobility and monetary policy
sovereignty; in reality though, IT-EMEs
are observed stabilising exchange rates
nonetheless (Fischer 2001). Likewise, the
UPC factors in reserve accumulation for
intervening in foreign exchange markets.
The risk here is of excessive focus upon
the exchange rate, transforming it into a
nominal anchor preceding the inflation
target. This need not always be the case,
but pursuit of two nominal objectives
cannot be ruled out, say, in a prolonged
capital outflow episode.
The second issue is of sterilisation
costs. The UPC made clear its preference
for a multi-pronged approach in conduct
of monetary policy in a globalised environment with primacy to interest rate
response. It highlighted sterilisation of the
liquidity impact of reserves accretions
as a key monetary policy challenge in
this regard, recommending (i) build-up
of a sterilisation reserve out of its
existing and evolving portfolio of government securities across maturities, with
accent on a strike capability for rapid
intervention at the short end; (ii) introduction of a remunerated standing deposit
facility to empower RBI with unlimited
sterilisation capability. The point here is of
costs that would devolve upon the public
balance sheet, either directly through
interest costs borne by the central government from payouts on higher-yielding
domestic securities, or indirectly by way of
revenues foregone on account of lowered
dividends transferred by the central bank
in the latter instance. Both contribute
towards an increased fiscal burden.
3 Conclusions
In his consideration whether inflation
targeting can work in emerging market
countries, Mishkin (2004) underlines
that developing strong fiscal, financial
vol l no 3

and monetary institutions is very critical


to the success of inflation targeting in
emerging market countries. Examining
the Brazilian and Chilean cases, he concludes that inflation targeting is more
complicated in emerging market countries
and is not really a panacea, but if done
right it can be a powerful tool to help
promote macroeconomic stability in
these countries. As this article reasons,
the timing of Indias transition to FIT,
viz, an adverse domestic and global
macroeconomic context, poses significant
risks to a successful implementation. In
particular, the possible output sacrifice
that may be significant could have an
impact on the evolution of supportive institutional structures necessary to carry
forward and build upon the credibility
of the new monetary regime.
The poor, uncertain global environment
of the post-crisis period has also cast
a shadow of doubt over the pre-crisis
evidence on inflation and output performances under IT-regimes.2 These studies
mostly concentrated on the post-1990s,
pre-crisis period when many countries
adopted IT frameworks. The evidence is
overwhelmed by the phase of Great
Moderation a time now understood as
having been an exceptionally benign economic environment of low, stable inflation combined with steady economic
growth that ended in 2007. The causes
of this reduction in macroeconomic volatility are still not fully identified, i e, if
macroeconomic shocks were simply
smaller because of good luck, or if
better policies including IT, promoted
stable growth and low inflation, is an
unresolved issue. This was also a period of
sustained, high Chinese growth rates that
sparked a long commodities boom, which
fuelled rapid growth in EME commodityexporters, many of whom shifted to IT at
the same time, and which facilitated sharp
reductions in net public debt-GDP ratios.
The larger macroeconomic shocks of
the post-crisis period have been recently
employed to re-examine IT experiences
across countries in an aggregate overview
by economists from the Bank of International Settlements (Banerjee, Cecchetti
and Hofmann 2013). They find that non-IT
EMEs enjoyed faster growth rates of 7.13%
on an average in 2000-06 and an average
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COMMENTARY

4.13% subsequently in 2007-12. On the


other hand, IT-EMEs grew more slowly in
these two time periods, an average, respective 4.51% and 3.65%. For Indias adoption of FIT, the national and international environments could be very critical in
the light of these doubts and risks.
Notes
1

14

Under this approach, a number of quantity


variables such as money, credit, output, trade,
capital flows and fiscal position as well as rate
variables such as rates of return in different
markets, inflation rate and exchange rate are
analysed for drawing monetary policy perspectives. Since the 2000s, these are supplemented
with forward-looking indicators drawn from
the RBIs surveys of industrial outlook, credit
conditions, capacity utilisation, professional
forecasters, inflation expectations and consumer confidence (RBI 2014: 8-9).
Comparing the inflation-output performances
in IT-countries before and after adoption of IT
with non-IT countries between 1991-2000 and
2001-09, Roger (2010) finds that (i) Both IT and
non-IT low-income economies experienced

major reductions in inflation rates and improvements in average growth rates; although nonIT countries continued to have lower inflation
and higher growth than IT ones, the latter saw
larger improvements in performance. (ii) Both
groups also experienced large reductions in inflation-output volatility, but IT-countries registered bigger declines, especially in inflation
volatility. (iii) Among high-income economies,
little change in performance occurred in the
IT-countries on average in these two periods,
whereas the non-IT set typically experienced a
decline in growth; likewise, the former group
experiences little change in output or inflation
volatility between the two periods, but output
volatility was higher in the non-IT group.

References
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