The long awaited Urjit Patel committee report on new operating procedures of monetary policy recommends flexible inflation targeting (FIT) and proposes a transition period of two years to the FIT regime.
The arguments for recommending consumer price index (CPI) as a nominal anchor and setting a 2-6 per cent CPI target in the medium term are radical steps and can be seen as a sincere endeavour against the backdrop of stubborn inflation since 2010-11.
The choice of CPI is well reasoned and guided by such transitions in other emerging market economies (except China). However, we believe, inflation targeting in a country like India will face some key operational challenges requiring a close co-ordination with the government.
This apart, after the financial crisis, the focus has shifted to financial stability. In short, there are some lingering concerns, which unless accommodated or resolved may render transition to FIT an arduous terrain.
First, global monetary imbalances may constrain the migration to the FIT regime in the coming two years.
Global monetary imbalances are characterised by structural deficit in the US balance of payment deficit, high inflation in creditor country and benign inflation in the US.
With QE (quantitative easing), the global monetary base has already expanded manifold over the last five years. Neither, the withdrawal of QE implies contraction of monetary base nor is monetary policy in other reserve currencies showing signs of contraction. This may continue to fuel inflation, including asset prices, as is already evident from the relentless march of the yellow metal from West to East in the latest World Gold Council Report.
Second, the choice of CPI in Western countries is guided by a different rationale. This is largely due to high household indebtedness, which would require central banks to ensure twin objectives: financial stability and preserving consumption during the revival phase.
In India, the rationale is not this. The household borrowings from several sources (use of credit card, etc) are very low, approximately at 10 per cent of the gross domestic product.
The entrenched culture of thrift (against consumerism in the West) in India will make preserving household savings an overriding concern of the central bank in India.
High CPI inflation has prompted household savings to migrate to gold. So long this vital component of household balance sheet is not internalised by the RBI (the committee is silent on this aspect), FIT may not produce the desired result.
Interestingly, in countries such as the UK, mortgage interest payments is included as an item in CPI to make the transmission more effective (absent in India).
Third, the choice of CPI has three inherent weaknesses. These are: (a) high share of food items in CPI (b) the fact that CPI does include data from PDS (public distribution system) shops may impart a downward bias on food prices in the CPI basket and (3) it is therefore prone to supply shocks.
FIT will, therefore, require overhauling the present monetary and fiscal co-ordination and including written understanding between monetary and fiscal arms, both at national and sub-national levels on price stability.
Price stability is on the concurrent list of the Constitution of India (item no 34: Price control). Hence, both the Centre and state governments are responsible for price stability.
Fourth, the rationale for a separate monetary policy committee (MPC) is usually to delegate decision to monetary policy experts.
In this context, we believe that the composition of MPC as mandated in the Urjit Patel panel report should have been more broad-based, with even representation from the government (akin to the UK) to have better monetary and fiscal policy inter-linkage.
In most of the countries, the government is represented on the decision-making body. Interestingly, the average size of the decision-making committee in targeting economies is around seven people, irrespective of the size of the economy.
Interestingly, on accountability, the proposal on fixing accountability of the MPC by issuing a public statement may not be adequate.
In this context, former RBI governor D. Subbarao had once said, “The governor goes before the Parliament Standing Committee on Finance twice a year to present a report on the Reserve Bank’s policies and outcomes and answers questions from the members of the Committee.”
To conclude, inflation targeting does have several potential benefits such as reducing the time-inconsistency problem of monetary policy, enhancing the credibility of a central bank, anchoring inflation expectations and offering more flexibility.
Although the potential benefits of FIT adoption are clear from the literature, the empirical evidence on its impact on inflation performance remains ambiguous.
For India, given the large fiscal dominance (in 2014-15, the government will borrow Rs 5.97 lakh crore) and the significant presence of informal finance, the implementation of FIT will require a combined effort on the part of all stakeholders. Interestingly, since the end of January this year, when the Patel committee recommendations were made public, interest rates continue to stay elevated, and likely to be so at least over the next couple of months.
The author is chief economic adviser of State Bank of India. Saket Hishikar co-authored this article. Views are personal