CEA: No inflation targeting framework is sacrosanct

The Economic Survey for 2023-24 questioned the merits of India’s inflation targeting regime, which aims at a headline inflation rate of 4% with a band of 2% on either side. 

It mused aloud whether a regime that targets inflation, excluding food prices, would be more appropriate in the Indian context, especially given the unintended effect it has on farmers’ terms of trade.

Some have opined that it is a settled issue and there is no point in opening it up. That is a strange and unfortunate argument. Nothing is settled in science, more so in social sciences. The relevance of theories, practices and policies is always subject to re-examination in the light of new empirical evidence and changing contexts.

Not so long ago, the case for free trade was considered settled, as was the case against industrial policy and fiscal laxity. Several apostle-countries of these policy doctrines have quickly abandoned them to the point of pretending now that they never held them sacrosanct. 

Also read: Monsoon rainfall boost in August likely to ease pressure on food inflation

Trade actions have soared. Industrial policy is now de rigueur, and a sustained fiscal deficit exceeding 6% of GDP is met with shrugs in policy circles.

Whether these changes are for the better or not is not the issue. But, as contexts change, policy shifts take place. That is par for the course. Else, there will be intellectual fossilization and ‘fossil’ is a bad word these days. Mercifully, in India, the question posed by the Economic Survey has sparked a lively discussion, and it is a good thing.

While the Economic Survey approached the issue from a farmer perspective, there are multiple reasons to question the inflation targeting framework.

First, it is axiomatic that someone can and should be held responsible only for outcomes that are largely under their influence or control. Is food inflation amenable to central bank or monetary policy influence? 

In the Monthly Bulletin for January, authors from the Reserve Bank of India conceded that food inflation was generally considered outside its ambit. So, it is unfair to the central bank to give it a target for inflation to be kept in check when a large chunk of it is outside its control. It can lead to policy errors.

Second, conceptually, short-term interest rates are policy tools to address cyclical fluctuations in aggregate demand. It is a different matter that, in recent decades, central banks in advanced economies used it as a long-term policy measure. 

Interest rates are unlikely to be effective in addressing supply-induced inflation, and, if anything, higher interest rates make addressing supply constraints more difficult by raising the cost of capital for investments—fixed or inventory.

Third, fiscal policy interventions are necessary to address supply constraints so that the higher inflation rate induced by such constraints can be attenuated. 

Also read: Retail inflation for farm, rural workers eases in July

Indeed, it is conceded that fiscal policy has a large role in inflation management. If so, that begs the question of whether fiscal authorities should be part of the decision-making apparatus for an inflation-targeting regime.

Fourth, there is a well-nurtured popular perception that inflation targeting is a neutral choice between different stakeholders in the economy. This is beguiling, but false. No public policy choice is neutral. They are political economy choices. 

Inflation targeting in advanced economies implicitly targets labour income, as central banks respond to an incipient acceleration in wages but not to profits. 

In developing countries, since food constitutes a large share of the price index, central banks implicitly target better terms of trade for farmers. There are other ways to relieve the burden on consuming households from higher prices.

Fifth, let us examine the claim, assumption or hypothesis that there is a risk of second-round effects of higher food prices affecting overall prices. It has to be grounded in facts. In the recent period of persistent food price inflation, non-food inflation has trended lower and not higher. Crucial evidence for the prosecution is missing.

Sixth, let us consider an alternative scenario: non-food inflation is rising; food inflation is non-existent, or there is food price deflation; the headline inflation rate is above 4%; will the central bank tighten policy or wait for second-round disinflationary effects from food price deflation to show up? It won’t wait. So, why is there an asymmetry in the policy response, then?

Seventh, inflation targeting by central banks is based on the premise of inflation being a monetary phenomenon. It is a model and a theory, not the theory. 

In the last three decades, there has been compelling empirical evidence that the theory has not held up well, except under extreme circumstances of outsized money supply growth leading to hyperinflation in a few countries. 

Japan could not stoke inflation despite decades of effort to boost money supply; other advanced nations failed in a similar mission after the 2008 financial crisis; post-2020, they succeeded because monetary and fiscal policies were jointly turbocharged and remained in active firing mode much longer than necessary. Inflation pressures were further accentuated by supply disruptions post-2022. Real factors clearly have a big hand in stoking inflation.

Unintentionally, the Bank for International Settlements in its Annual Report for 2015-16 propounded an alternate theory of inflation generation: “(Low inflation) would especially be expected in a highly globalised world in which competitive forces and technology have eroded the pricing power of both producers and labour and have made the wage-price spirals of the past much less likely.” 

In other words, the degree of globalization and free trade, competition and technology, as also the pricing power of producers and labour, will determine whether inflation is low and stable or high and rising.

Also read: Fighting food inflation isn’t a challenge for a single fighter

India adopted its inflation-targeting regime in 2015 after a long period of average annual double-digit inflation between 2009 and 2014 caused by a combination of accommodative monetary and fiscal policies that overstayed their usefulness. Until then, among developing nations, India had a better inflation record. 

Its ‘multiple indicators’ approach was doing its job. Indeed, after the 2008 financial crisis, the emerging consensus was that multiple indicators were the way to go as accelerating inflation (or its absence) was deemed an imperfect and even a misleading sign of the health of aggregate demand growth in the economy.

In sum, discussions on the merits of an inflation-targeting framework, the metrics chosen and their numerical values are neither settled nor sterile, but salient.

These are the author’s personal views.