Indira Rajaraman: Targeting only inflation?

The January 2014 report of the Reserve Bank of India Expert Committee to Revise and Strengthen the Monetary Policy Framework recommends switching to inflation targeting, instead of a more flexible multiple-indicator focus on financial stability. The report cites evidence from other countries to support its case. It suggests convergence over two years to a target inflation rate, measured by the consumer price index (CPI), of four per cent with a two per cent band on either side.

The recommendation has a strangely dated ring, this side of the great global crash of 2008. There is a difference between committing monetary policy to delivering low and stable inflation, as every central bank must, and a prior declaration of an inflation number (or band), to which alone monetary policy will dance, without reference to what is happening to unemployment and growth. Single-focus inflation targeting is nowhere nearly as confidence-inducing as a policy commitment to financial stability, of which stable, and hopefully low, inflation will be a component.

Since all prices do not rise in tandem, measuring inflation involves assigning weights by their relative importance to consumers. It is only since January 2012 that India has had a single nationwide CPI (split into rural and urban), to replace the earlier three indices, each relevant to a broad occupational group (which still exist, and are issued independently by the Labour Bureau).

Starting from the 1973 oil price shock, inflation is looked at in both its headline form, which is the average across everything, and in terms of a core, which excludes components subject to exogenous shocks, from weather (food), or other externally originating supply uncertainties (fuels). The core conveys information on the inflation-generating dynamic within the system. It could be influenced by non-core elements, as when wages are indexed to keep up with prices of fuel and food, or not so influenced. Core inflation then becomes the barometer of inflation as an endogenously generated disease, which, by common consensus, introduces uncertainty and reduces the incentive to invest. High core inflation is a growth killer (although what really matters is uncertainty resulting from variability in the core over time and across components rather than the average core rate just by itself).

Food carries a weight of 48 per cent in the CPI (not including intoxicants). The core is almost as important, at 43 per cent, and fuel accounts for the rest. Food inflation has gyrated wildly in the 10 to 15 per cent range for much of the last two calendar years, as a result of causes too widely known to warrant repetition. Because of the lower and more steady core, the headline rate has settled to a sedate trot around the 10 per cent mark (dipping in January 2014 to just below nine per cent). The core has come to rest since August 2012 at a steady and sticky eight per cent (where it remained even in January despite the headline dip).

This core needs to be unpacked. Housing, the largest component, has held steady and high in the 10 to 11 per cent range. Clothing has climbed down from 15 to nine per cent, but is clearly holding up the core rate. The remaining elements in core inflation, mostly an assortment of services, are either holding steady at or have fallen to levels in the five to eight per cent range.

Housing dominates the core, with a weight of 23 per cent. Since housing has no weight at all in the rural index, this is because of its high weight within the core of the urban index, at 40 per cent. Even that probably understates the impact of housing inflation in urban India, where housing rentals can equal the sum of household expenditure on everything else including food. Supply constraints drive housing inflation, due to the impossibly throttled market for land, in conjunction with transport constraints, which call for housing near the workplace.

Shift now to the most recent GDP figures. Growth in the service sector, a hardy perennial of the Indian economy, has come to rest at what by historical standards is a low level of a little over six per cent over the last two years. When this is unpacked, you see that construction has gone into a deep dive, from 11 per cent growth in 2011-12 to between one and two per cent over 2012-14. Because of this, it is unlikely that housing inflation will climb down any time soon.

I am making three points here. First, reported inflation, whether headline or core, probably understates inflation as it is being experienced today because the actual weight of housing is higher than the assigned weight even in the urban index. The second is that housing inflation is likely to continue for the foreseeable future because construction has ground to a halt, and can possibly ease in a few years' time only if supply constraints in housing are addressed immediately. (Luckily, there are some stroke-of-the-pen reforms that can enable this, such as re-zoning industrial estates as multiple use land, so as to permit low-cost housing for industrial labour within those areas.)

The third point, given this supply-driven configuration of Indian inflation in its key drivers today - food and housing - is that there is little monetary policy can do to control inflation. In fact, a rise in policy rates could actually worsen housing inflation, since equated monthly instalment payments are the first to transmit a rise in policy rates, and potential buyers on EMIs will fall back on rental housing, with knock-on effects down the line.

Even central banks in emerging economies that have declared inflation targeting watch the US taper, for its impact on capital flows and exchange rates. The armour of inflation targeting is probably donned more to reassure foreign capital of a predictable policy configuration, and therefore to guard against inward or outward capital surges, and ensure exchange rate stability. At the end of the day, a central bank derives credibility from the financial stability it is able to deliver by responding flexibly to the need of the hour, rather than from the fact of having strapped itself into a one-indicator straitjacket. There can even be downsides to formal inflation targeting, if it makes the central bank feel compelled to wiggle the policy rate every time there is what may well be a short-term upward tick in the headline CPI, just to demonstrate alertness and vigilance. Policy rates take time to transmit through the system, and constant up-down changes in policy rates lead to directional confusion in monetary transmission.

The writer is a retired professor of economics