Inflation In Age Of Innocence

Perhaps one of the most arguable recommendations in the Tarapore committee report on capital account convertibility pertains to a parliament mandate for inflation.

The committee has argued that most often monetary policy works at cross purposes with the fiscal policy. To avoid this, it has recommended that parliament should mandate a level of inflation consistent with its fiscal philosophy, as laid out in the budget. The central bank, then, should use all the armoury at its command to fulfill the mandate.

The committees faith in parliament being able to arrive at a consensus inflation number is touching indeed. More so, because the committee deduces that such an arrangement will in fact work a long way towards enhancing the autonomy of the central bank!

 

It can possibly be argued that giving the responsibility of targeting inflation would make parliament more aware of the consequences of the fiscal policy that is debated in the august house. Carried to its logical conclusion, this would mean the end of one major component of monetary policy. The know-all government starts with an inflation figure and works its way back through fiscal policy. The central bank only has to draw its armoury whenever inflation threatens to move out of the target range.

The flaw in the argument, however, is that inflation is too important an issue to be left to parliament. Even the most sauve finance ministers in the world cannot but give in to the temptations of short term gains, even if it means compromising with long term goals. The German finance minister, Theo Waigel, for instance did not think twice before proposing that the countrys gold reserves be revalued. His only short term objective was to push the deficit numbers to meet with the EMU convergence criteria.

The usual arguments against the sad innocence of our parliamentarians for matters economic apart, the more relevant issue is why should the central bank need a mandate? From parliament or anywhere else? The job of a central bank is first and foremost, to prevent inflation. Theoretical constructs of a natural rate of inflation, or of a natural rate of unemployement may have been discredited, but the fact remains that all monetary policy has an in- built inflation target. The mandate arises from within: the central banks perceptions of the growth impulses in the economy and its sustainability.

In the developed economies, with perfect mobility of capital, this inflation target is perhaps given by the inflation rates in competing economies. But where capital restrictions apply, perhaps the central bank is guided to some extent by the trade off involved in lower unemployment and inflationthe Philipps curve.

It is therefore all the more relevant in developing countries that monetary policy act as a bulwark against loose fiscal policy. For governmentsanywherecommitted to full employment would tend to take an easy view on inflation to push the broader agenda ahead.

This leads to two questions. First, what does the government know? And second, what can the government do, assuming that it ventures into an inflation number?

On the first count, precisely nothing, going by another of the recent skirmishes between the treasury and the central bank. When in February 1995, the US Federal Reserve raised interest rates by 25 basis points in the celebrated pre-emptive push against inflation, the treasury secretary raised cain, saying the Fed was seeing phantoms where none existed. The Feds cautious reply is a classic to this day: one is either pregnant or not pregnant. So also there is no such thing as a little bit of inflation. The Fed was later proved right but not before a series of sixor eight?interest rate hikes that stamped out the last of inflationary impulses.

Indeed, the proposal for a parliament mandated inflation is worse compounded because it leaves leeway for a subsequent correction. It may just be understandable that parliament commits itself to a three per cent inflation level in the medium term. But setting an annual target, subject to periodic reviews, calls for no accountability on the part of the government. It is for a fact that given the structural inadequacies in the Indian economy, inflation is largely driven by supply side shocks. It is not difficult to see that phases of high inflation in the country have little correlation with the fiscal deficit, but have been driven in large measure by external shocks.

To the extent fiscal policy tends to be accomodative of the consequences of such shocksas public works after a failed monsoonit only succeeds in perpetuating the inflationary trend. Taking the prerogative of inflation busting away from the central bank indeed makes the whole exercise self sustaining as well as self consuming.

One does not have to look very far for the consequences of a backward looking fiscal policy. Wages in the government sector, for example, are indexed for inflation in the previous periodsix months to one year. To that extent, wages tend to perpetuate the inflationary trends in the previous period, leading to what is usually called the wage-price spiral.

As to the second issue of options before government, there is only one. Government will have to run the largest central planning exercise anywhere in the world.

Consistent with its inflation forecast, government will have to gets its hands on each of the markets in the economy. It will have to dictate, to the last digit, the behaviour of the labour market. It will have to dictate prices in the commodity markets and each of the product markets. It will have to dictate the level of mark ups in the manufacturing industry. In fact, government will have to be everywhere, if it has to be held accountable for its inflation targets.

It is not for nothing that nowhere in the world does government dabble with inflation numbers.