In its World Economic Outlook, the IMF said that after the ongoing “great recession”, central banks should rethink their position on inflation targeting.
The Financial Sector Legislative Reforms Commission (FSLRC) report too did not insist on inflation targeting. The central government can specify price stability, a fixed exchange rate, or the nominal GDP as the predominant objective in consultation with the RBI.
But, both the IMF and the FSLRC report said that global macroeconomic stability was troubled the least after the major central banks had adopted inflation targeting.
In 2008, the Committee on Financial Sector Reform headed by Raghuram Rajan had said that the RBI should focus on price stability. But, many economists including the RBI governor Duvvuri Subbarao argue that inflation targeting might not work in a developing country where the central bank needs to balance between growth, price stability and financial stability.
Subbarao had also said that supply-side constraints are the primary cause of inflation in India.
Unlike the major central banks, the RBI does not have an inflation target. So, the international experience is worth examining.
As usual, inflation targeting began in the United States. In 1971, the US cut the link between the dollar and the Gold. Soon other countries followed suit. Inflation started rising to unprecedented levels in the US and the other industrial nations. Like in today’s India, the inflation of the 70’s was blamed on the rising oil prices, and various external factors.
Like in today’s India, many economists had believed that with rising inflation unemployment would fall. Low growth was also associated with high inflation. But, in the 70s, with high inflation, growth fell and unemployment rose.
Economists now generally agree that inflation has no beneficial effects.
Ajay Shah, a co lead of the technical team of the FSLRC thinks that the economists who say that India's case is somehow different have never shown evidence from within the country to substantiate their claim.
In 1979, the Fed decided to have monthly target rates for the growth rate of M1. (M1 consists of the public’s holdings of currency and the checking account deposits in banks and other depository institutions) In 1971-81 period, the inflation in the US was in double digits, but, something changed after that.
For close to three decades, inflation in the US was steady, but historically low. Fluctuations were mild till the ongoing global slow down. This is historically unprecedented.
"In the 70's, like the RBI, the US Fed had said that inflation was a supply side phenomenon, and that monetary policy was not to be blamed. But, inflation fell only after the Fed started implicit inflation targeting.” Ila Patnaik, a co-lead of the technical team of the FSLRC said.
But, it was not the US experience that convinced the monetary authorities worldwide. In the 70's and 80’s, inflation in New Zealand was higher than in other OECD countries. In 1988, the CPI inflation in New Zealand was 9%. Inflation targeting began in 1990, and by 1991, the inflation was down to 2%. Inflation and output volatility declined. By 1994, New Zealand was among the fastest growing OECD countries. In the financial year 2012-13, prices fell in New Zealand, month after month. It was so remarkably successful.
A controversial clause in the FSLRC report is that the central government can specify the publicly stated quantifiable objective of the monetary policy. Many think that this will dilute the independence of the RBI. But, such accountability was precisely what triggered tremendous public support in favour of the instrumental independence of the Reserve Bank of New Zealand.
After a legislation mandated that the Reserve Bank of New Zealand governor could be fired for inadequately meeting the inflation target, the two major political parties voted in favour of central bank independence.
“To make government agencies work well, we have to set up feedback loops of accountability. This is a key point emphasized in the Indian Financial Code that has been drafted by FSLRC.", Ajay Shah said.
Initially, the success of inflation targeting was attributed to luck, or to central bank heads. But after 1990, dozens of central banks across the world successfully adopted the same strategy, not just in countries like Australia and the UK, but in also in many low income countries.
Today, advanced countries with inflation targeting central banks rarely have inflation rates above 2%. In the last two decades, central banks have become the most efficient government-created institutions in developed countries.
The rising fiscal deficit is considered another triggering factor behind India’s inflation. But, deficits are inflationary only when the RBI monetizes the government’s debt.
“In India, the centre's fiscal deficit is monetized by the RBI. If India had a truly independent central bank, long-run inflation would have been a purely monetary phenomenon.” Bibek Debroy, a research professor at the Centre for Policy Research said.
After the automatic monetization of the government debts was repealed in 1997, India had greater price stability. The high growth rate India enjoyed also roughly coincided with this period. The annual inflation in 2001-2002 was only 3.8%, though the fiscal deficit was 6.2% of the GDP, which is much higher than the fiscal deficit in 2012-13, which is 5.2% of the GDP.
The good times lasted till the RBI started lowering the interest rates to maintain an exchange rate peg.
“In 2009-10, the annual inflation was 10.2%, and this is often attributed to drought. But, 2001-02 was also a drought year and the fiscal deficit was quite high, but we had price stability.” Soumya Kanti Ghosh, a professor at ICRIER said.
Ila Patnaik said that like the US, India too had price stability only when the RBI was serious about tackling inflation. “Because long-run inflation is a purely monetary phenomenon, the central bank should target inflation. Low inflation is conducive to economic growth.”, she said.
Even in the UK where the fiscal deficit is huge, the inflation in March 2013 was only 2.8%. The UK has an independent debt management office. The Bank of England does not have to inflate the country out of debt, and that is true of other major central banks. The success of inflation targeting is attributed to the central bank focusing on price stability, and not pursuing a laundry list of often mutually conflicting goals.
“When the central bank has multiple goals, there will be a loss of accountability. The RBI generally does not like accountability, and hence has avoided clarity of purpose. In other countries, it is the politicians who drive monetary policy away from the goal of price stability. In India, it is the other way round. This is the odd state of economics in India.” Ajay Shah said.