Setting goals

The pros and cons of inflation targeting

Reserve Bank of India (RBI) and the finance ministry have agreed to put in place a monetary policy framework, which will make flexible inflation targeting the official goal of the central bank. Till January 2016, the RBI will target a consumer price inflation rate of below six per cent; from 2016-17, the target rate will be between two per cent and six per cent. This has been a long-standing demand of the RBI under Governor Raghuram Rajan, and largely follows the suggestions made by a panel chaired by Deputy Governor Urjit Patel. It is to be hoped that the composition of the monetary policy committee will reflect the RBI's independence: it should have knowledgeable experts as members and the RBI governor should chair it. In particular, the government should not have a nominee on the committee.

While, in general, this mechanism is welcome - since it brings to India the formal accountability and transparency about future actions that is the hallmark of modern central banking - there are some important caveats that must be made. In particular, it is far from certain that the RBI can, in fact, sustainably deliver what it is being asked to do. In the Consumer Price Index (CPI) inflation, which is what the RBI will target, the weight of food items is around 50 per cent. But food inflation in India is usually caused by non-monetary factors. This country suffers from volatility of production and problematic supply chains; and so a failed harvest or a temporary shortage of onions could send the CPI reeling. Under those circumstances, there is little that monetary policy can do other than make sure that it does not develop into generalised inflation. Of course, the monetary policy transmission mechanism is in any case weak, thanks to India's lack of fully developed and integrated financial markets. That means that, sometimes, the RBI may signal intent with interest rates, but they may not have much real impact. Overall, thus, the RBI may find delivering on an inflation target harder than central banks in countries where food is not central to inflationary pressure, and where transmission systems are more effective. It is worth noting that even in advanced economies, single-goal targeting is no longer the only monetary game in town. Since the 2008 crisis, central banks have considered other systems, including targeting nominal gross domestic product (GDP).

True, there are reasonable counter-arguments to this position. One is that the range given to the RBI for its target inflation is quite broad - two per cent to six per cent - which should cover most situations. Even if the RBI fails to hit the target zone for three quarters in a row, all it needs to do is simply explain the reasons - like excessively loose fiscal policy from the government, or a failed monsoon. Fiscal irresponsibility, of course, the RBI has no control over. The Fiscal Responsibility and Budget Management Act, or FRBM Act, tends to be breached repeatedly by the government. Once a separate debt management office has been created, as promised in this Budget, the RBI will even not be in control of the government's debt programme. Given that, it will just have the interest rate as a lever of control; thus, the constant threat of fiscal excess from the government could mean a continually tough interest rate regime. The effects on growth are easy to imagine.