Inflation debate must consider downsides of alternative frameworks

An interesting and lively debate, including on this page, has ensued on India’s inflation targeting, after this year’s Economic Survey in July suggested that the framework should consider targeting inflation excluding food. Economists in the finance ministry reasoned that higher food prices are often supply-induced rather than being demand-driven. Further, short-run monetary policy tools are meant to contain price pressures emanating from excess aggregate demand growth. Several commentators have argued that this debate is settled and the Reserve Bank of India (RBI) must continue with the current framework because it has served India well. In this regard, in a piece published in Mint this week, Chief Economic Advisor V Anantha Nageswaran noted: “Nothing is settled in science, more so in social sciences.” It’s hard to quibble with the argument. Policies, particularly in a large and complex economy like India, should indeed be constantly debated and refined with changing realities and development needs.

To be sure, the inflation-targeting framework adopted in India is different from the earlier approach in at least two aspects. First, the government was empowered by the RBI Act to set an inflation target in consultation with the central bank, subject to review every five years. The target was set at a 4 per cent consumer price inflation rate with a tolerance band of 2 percentage points on both sides. This helped the general market understanding, and made monetary-policy decisions more predictable and easy to understand. Second, monetary-policy decisions are now taken by a six-member Monetary Policy Committee (MPC), which has three external members. This has increased transparency and significantly reduced pressure on the RBI governor, who essentially took the call in the earlier system. Thus, it is reasonable to argue that the framework is an improvement from what India had before. In the earlier system, policy decisions sometimes became difficult to communicate because the central bank was targeting multiple indicators with one policy instrument.

The other aspect of the debate is whether the nominal anchor for monetary policy is correct or whether India would be better off targeting inflation without food as proposed by the Economic Survey. To be fair, the RBI or the MPC on its own cannot change the target or stop taking into account one part of the consumer basket without appropriate amendment to the RBI Act. The Act mandates the government to decide the target in terms of the consumer price index-based inflation rate. Parliament can only be persuaded to amend the law if there is enough analytical evidence to justify the shift. The target was adopted following the recommendation of an expert committee. Subsequent research by economists at the RBI and elsewhere has shown that the framework has worked well for India.

The central bank can always ignore transitory spikes in food prices. However, as a recent research article by RBI economists highlighted, persistently higher food prices put upward pressure on core inflation. Any shift in the target will thus need to be backed by analytical evidence showing India will be better off with the RBI targeting core inflation or any other indicator. It is also possible that an optimal core-inflation target or just inflation without food may not be 4 per cent. Any shift in the framework also runs the risk of de-anchoring expectations because it could be read as the system’s inability to contain headline inflation. Besides, any such debate should not ignore savers. Since households contend with consumer price inflation, a negative real interest rate could impact savings and investment, thereby increasing growth and financial-stability risks.