Inflation targeting in India: select issues.

Author:Singh, Charan
Position::Report
 
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Abstract

Adoption of inflation targeting in India has been a much debated topic which also becomes a challenge for the emerging economy. Though inflation targeting has already been adopted in many countries, acceptability in India is a matter of concern. The paper argues that India needs to consider the composition of consumer price index; state of macro econometric models; young demographics, unemployment and lack of social security before adopting inflation targeting.

To modernize the monetary policy framework, India could consider introducing regular review of the regional economy; instituting a Monetary Policy Committee; separating debt from monetary management, the paper argues.

Jel Codes: E310, E370, E580

Keywords: Inflation, Inflation targeting, Monetary policy, Consumer price index

INTRODUCTION

Inflation Targeting could be the next major policy measure adopted in India as the proposal is under active consideration by the Reserve Bank of India (RBI) and the Government of India. In recent years, there has been a debate on the monetary policy framework in the country, basically anchored around the philosophy of adopting inflation targeting (IT) in India.

IT targets the inflation rate and not the price level and is distinct from monetary targeting and interest rate targeting. IT regime assumes that price stability is explicitly the mandate; a quantitative target for inflation is publicly announced; monetary policy is based on an inflation forecast; there is transparency in monetary operations; and that accountability mechanism is in place [Roger, 2010; Hammond, 2012],

In this brief and focused article, select issues on implementing inflation targeting in India are discussed. The evolution of inflation targeting and relevant experience of select countries is presented in Section 2 of this paper. Section 3 presents a discussion on applicability of inflation targeting in India. Modernisation of the monetary policy framework in India is examined in Section 4 and finally, conclusions are presented in Section 5.

SECTION 2: EVOLUTION OF INFLATION TARGETING: SELECT EXPERIENCES

The key policy objective of central banking is price stability, and the concept of giving it a numerical precision was considered very modern after monetary and exchange rate targeting had failed in the 1980s. The hunt for a better target led to experimentation with a checklist of economic indicators by Australia in mid-1980s and explicit squeezing of inflations rate by New Zealand by late eighties [Singleton, 2011]. After some trials and initial success, the IT regime was formally inaugurated in March 1990 in New Zealand with the negotiation of the first Policy Targets Agreement between the Government and the central bank. Historically, some countries, of which a few at the push of the International Monetary Fund (IMF), switched to IT after the successful adoption by New Zealand (1990), Canada (1991), and UK (1992). The spread of IT was contagious and according to Mahadeva and Sterne [2000], 54 countries had adopted IT by 1998. And, by 2004, according to Rose [2007] formal inflation targeting was in place in a number of countries making up one-quarter of world economy. The situation changed after the recent financial crisis and rethinking of the economic strategies that went wrong before 2008 compelling many economists and policy makers to conclude that the role of economic blinkers that IT imposed on the policy makers cannot be ignored [Frankel, 2012], Marcus [2014] observed that application of IT in an emerging country like South Africa faced many challenges - opposition of the trade union; disagreement on limits of transparency; arguments whether IT regime was sufficient to ensure price stability; and finally, questions of the level of targets. It probably is for similar reasons that none of the countries have adopted IT after 2008, except Japan in 2013 but with a different motivation.

The price indices used for inflation targeting, the target band for inflation, the horizon and the speed of approach to inflation targeting is different for different countries even if analysed amongst the advanced and emerging countries (Annex I and II). Most of the countries use CPI (Consumer Price Index) as the index for targeting inflation (Table 1). Also, the target horizon is about two to three years.

FEATURES OF INFLATION TARGETING

The target horizon and the accountability for not adhering to the target is different for different countries though, the time horizon for most of the countries is on the medium term. (Annex III). Most of the countries use CPI (Consumer Price Index) as the index for targeting inflation. Amongst the important features of IT, in most of the cases, target horizon for operation is six to eight quarters and in some cases, even three years. In most of the cases, sophisticated models like dynamic stochastic general equilibrium (DSGE) models, autoregressive time series models and semi-structural models are used taking into account quarterly data (Annex IV). To inspire confidence in the market, in almost all the cases, forecasts are regularly and transparently disseminated along with the assumptions.

EXPERIENCE WITH INFLATION TARGETING

Inflation targeting ushered in transparency and accountability in the monetary policy framework but was criticized by Keynesians and monetarists for causing unemployment and monetary brutalism [Davidson, 2006]. Another common criticism was that it ignored asset prices [Singleton, 2011]. Also, most damaging was the fact that there was no conclusive proof that IT resulted in lower and less variable rates of inflation [Ball and Sheridan, 2003; Borio and Filardo, 2007]. In fact, in advanced countries, it emerged that IT and non-IT countries conduct monetary policy in a similar way--applying the Taylor Rule (TR), named after the famous Professor John Taylor of Stanford University. Also, interest rate adjustments are attempted by the central bank based implicitly on TR which implies calculation and forecast of output gap and deviations of inflation from the stipulated target. The estimation and forecast of output gap, and interest rate path involve use of many sophisticated econometric tools. Thus, adoption of IT was necessary as the level of inflation was higher than normally expected in most of the countries in the years before adoption (Table 2).

Marcus [2014] on reviewing the experience of South Africa cautions that IT involves many contentious issues especially when applied to emerging markets which are distinct from those faced by advanced countries. In fact, in most of the cases, targeters did not benefit much from the adoption of IT as statistical analysis reveals that inflation has been volatile in most of the countries even after adoption of IT (Table 3 and Table 4).

Also, inflation has not been very high in most of the countries which did not adopt IT (Table 5).

SECTION 3: INFLATION TARGETING AND INDIA

The argumentative Indians have been debating the adoption of IT for nearly two decades. In different publications of the RBI [1996; 1997] the issue of IT was discussed. Again, in 1999, a general discussion on inflation targeting in India started after the L. K. Jha Memorial lecture by the Governor of the Reserve Bank of New Zealand in 1999 on how New Zealand's experience with IT can be relevant for developing countries [Brash, 1999]. Further, a number of Committees set up by the RBI [2000], Government of India [2007] and Planning Commission [2009] also recommended the implementation of IT. The debate received a fresh impetus when Rajan [2013], in his first speech as RBI Governor, again emphasized the importance of low and stable inflation for Indian monetary policy and thereafter, in January 2014 the Expert Committee of the RBI to Revise and Strengthen the Monetary Policy Framework (RSMPF) submitted the report recommending adoption of IT by January 2016 with headline CPI as a nominal anchor.

India does not have an implicit IT regime but generally, in policy making, general price level was an important consideration given the living standards, size of informal sector and incidence of poverty. Therefore, India has always been a low inflation country compared to other countries, especially amongst emerging and developing countries. In India, inflation measured by a traditional measure of Wholesale Price Index, started before independence, has been generally less than 9 percent and if measured by the Consumer Price Index (industrial workers) less than 10 percent [Mahajan, Saha and Singh, 2014].

The application of IT could be riddled with many difficulties [Reddy, 1999; Jalan, 2000; Gupta and Sengupta, 2014]. The most important consideration in India is supply side constrains that contribute to inflationary pressures, especially for food items and fuel. A related aspect is lack of critical appreciation of supply constraints. To illustrate, recently, when onion prices were shooting up, an influential segment of population was happily concluding that farmers, an important vote bank, are the beneficiaries. The recognition of causes and economic implications of such "onion" episodes is lacking in policy making. In India, where still about two-third of agriculture is dependent on rain, and suitable supply-chain is lacking, supply side factors would continue to play a significant role in food prices.

In view of the fact that food prices are dependent on monsoons, the ensuing climate change is expected to put pressure on the food prices. In addition, food prices have been stubborn in recent years and are also impacted by the minimum support prices (MSP) of food grains which despite having risen significantly in recent years, are under pressure for further revisions on account of rising cost of farm equipment [Sonna et al., 2014; Gupta and Siddiqui, 2014], The Food Security Act, 2013, (FSA) which has assured food availability to nearly 80 crore people in the country are also expected to distort food prices. FSA has already...

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