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Infl ation Targeting as Policy Option for IndiaEvaluating the Risks

Renu Kohli

Infl ation targeting may have its benefi ts but the timing of Indias ongoing transition to IT an adverse domestic and global macroeconomic context poses signifi cant risks to a successful implementation. Moreover, the evidence of IT having a positive impact comes from the pre-fi nancial crisis era; more recent studies of the emerging market economies over a longer period show the non-IT countries growing faster than those which have adopted IT.

Renu Kohli (renukohli@yahoo.com) is a New Delhi-based macroeconomist; she currently leads the fi nancial globalisation research project at NCAER as an external consultant.

1 Introduction

In January 2014, the Urjit Patel Com-mittee report proposed a new frame-work for monetary policy fl exible infl ation targeting (FIT). Several argu-ments were made in justifi cation of a change from the previous, multiple-indicator1 based structure, chiefl y in re-sponse to its perceived failure and credi-bility loss from the inability to control elevated, persistent infl ation for some years (para II.17, p 9, Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework, Chairman: Urjit Patel; hereafter has referred as UPC). While a formal adoption of the new framework is being discussed with the government, the Reserve Bank of India (RBI) has accepted one of its key recom-mendations, viz, shifting over to con-sumer price infl ation (consumer price index, CPI) as the clearly defi ned nominal anchor and adoption of a two-year glide path to prepare the initial conditions ahead of formal adoption.

Infl ation targeting (IT) as a macro-economic policy tool is now more than two decades old, with varied country ex-perience. It is distinguished by an ex-plicit central bank mandate to pursue price stability as the primary monetary policy objective and a high degree of op-erational autonomy; explicit quantitative targets for infl ation; central bank account-ability for performance in achieving the infl ation objective mainly through high-transparency requirements for policy strategy and implementation; and a policy approach based on forward-looking assess-ment of infl ation pressures, incorporating a wide array of information (Roger 2010). The central bank publicly announces a projected, or target infl ation rate and then endeavours to guide actual infl ation

towards that target, using the interest rate tool. A nominal anchor variable is required to tie down the price level (Jahan 2012).

The framework works through a stable, predictable link between the policy rate and the infl ation rate, with rule-based monetary action (Taylor rule). Operation-ally though, IT works more as constrained discretion as the precise numerical target for infl ation is achieved over the medium term, allowing policy to respond to short-term economic shocks, e g, smoothing output. It is underpinned by Friedmans (1956) insight that there is no long-run trade-off between infl ation and growth. A short-run trade-off in which higher growth can be obtained at the cost of higher infl ation may exist but the two are independent in the long run; there-fore, central banks should focus on what they can infl uence, viz, infl ation. Because a short-term infl ation-growth trade-off may tempt a central bank to occasionally favour growth (principle of dynamic inconsist-ency, Kydland and Prescott 1977), an IT regime seeks institutional structures binding central banks to commit to a low infl ation target acceptable to the public. Once a belief that infl ation will remain low is established, public confi dence that the medium-run infl ation outlook will not change much even when shocks occur, will follow. The thrust of the framework is recognition of inconsistency in the pursuit and achievement of multiple goals, infl ation and unemployment (or growth) with only one instrument (interest rate). The overriding emphasis upon price stability makes it the primary objective of monetary policy, while the weights on growth are reduced. Thus growth and employment matter in IT only to the extent that a commitment to a medium-term infl ation objective remains credible.

Against this backdrop, Indias shift to FIT has only just begun, i e, public announcement of a two-year glide path 8% headline CPI infl ation by January 2015 and 6% by January 2016 towards a medium-term (4% 2 band) infl ation target. Correspondingly, the RBI adjusted its policy (repo) rate to 8% in January 2014; currently, it is on course to achieve

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the January 2016 target (6%). The government too has endorsed the new framework; it is comfortable with the me-dium-term infl ation target as refl ected from statements of the RBI governor and the fi nance minister. Essential support structures like legislative changes to make price stability the primary goal of RBI, performance accountability, operational autonomy as well as supportive institu-tional structures required for successful FIT are yet to follow. Hence, this article will only evaluate the implications of an increased infl ation focus, the shift from producer to consumer price infl ation for monetary policy setting, and the peculiari-ties of the structural, fi scal and institu-tional backgrounds. The stressed national and global macroeconomic environments, it is argued, make the shift to infl ation targeting a risky policy option.

2 Implications

Several analysts consider adoption of infl ation targeting as the most signifi cant reform of 2014. As with most reforms, the macroeconomic setting matters insofar as timing is often quite critical for accept-ance and eventual success. For example, a strong economic cycle characterised by buoyant tax revenues, robust incomes and profi ts, etc, facilitates reforms that otherwise may be costly, including politically so, simply because of the partial shield it offers. The opposite is true in hard times, which can complicate, slow down, or even overturn the reform process in extreme cases. On other occasions, e g, a currency, banking or fi nancial crisis, reform is unavoidable, making irrele-vant the macroeconomic context. We ex-amine the implications of the early steps towards infl ation targeting in this light, focusing upon some critical aspects.

Figure 1 and Table 1 provide a snapshot macroeconomic profi le at the time of transition. At the eve of the shift, Decem-ber 2013, consumer and producer (whole-sale) price infl ation were a respective 9.9% and 6.4% while real GDP growth was 4.6% in October-December 2013. Fiscal gaps were enlarged, while corre-sponding current account balances were alarming in 2011-12 and 2012-13. The exchange rate, after respective real and nominal effective appreciations of 8.5%

and 2.9% in 2010-11, depreciated steadily from 2011-12: an annual average of 6.6%, 10.4% and 7.7% in nominal effective terms (36-currency, trade-based, 2004-05 base) in the three years to 2013-14, with corresponding real effective deprecia-tion of 2.1%, 4.3% and 2.2%.

In stock terms too, the external balance sheet steadily (Table 1, Col 7) deteriorated as short-term external debt rose fast, foreign exchange reserves declined and external vulnerability increased. At the balance sheet level, fi rms and banks were signifi cantly stressed as observed from high levels of non-performing and restructured assets: in March 2013, 24.4% of the total loan portfolio of scheduled commercial banks was stressed, with near-similar share (23.9%) in March 2014.

A fair interpretation then is of an eco-nomic cycle at its trough, high infl ation, internal and external imbalances that combined towards steep, cumulative exchange rate adjustments triggered by sudden capital outfl ows in these years. It is an open question whether infl ation tar-geting responded to these developments and bind macroeconomic policy discipline.

Finally, the global economic environ-ment was, and continues to be adverse

and uncertain: World output growth has trended around 3% annually from 2011, with steady lowering of growth forecasts each year; growth in merchandise trade volumes plunged from 13.9% in 2010 to 5.4% in 2011, then more than halving to 2.3% and 2.2% in 2012-13 and was projected to be 3.1% in 2014; advanced countries continue to fl it between monetary and fi scal policies by turn, avoiding structural reforms; while China is on a permanently slower growth path.

While the UPC extensively considered infl ation performance, a discussion of macroeconomic settings and their bear-ing upon timing of the transition does not fi gure in the report. It must also be underlined that not one, but two struc-tural changes have taken place with the transition to FIT: One, price stability is now the primary policy objective. Two, the nominal monetary policy anchor is consumer price infl ation against producer price infl ation previously. What risks do these changes pose? Some key aspects are discussed here.

Output Sacrifi ce or Disinfl ation Costs: The interplay between the two changes imposed by the new monetary policy

Table 1: India Macroeconomic Profile GDP Fiscal Deficit Current Interest Net Net Intl Forex Import (in %) (Centre) 1 Account1 Inflation2 Rates3 Capital ac1 Invt Position1 Reserves1 Cover4

2008-09 6.7 6.0 -2.3 8.3 8.0 0.6 -5.1 13.8 9.8

2009-10 8.6 6.5 -2.8 10.9 4.9 3.8 -11.6 18.3 11.1

2010-11 8.9 4.8 -2.8 12.1 5.5 3.7 -12.8 16.1 9.5

2011-12 6.7 5.7 -4.2 8.9 7.6 3.6 -13.2 14.1 7.1

2012-13 4.5 4.9 -4.7 9.7 8.1 4.8 -17.3 9.8 7

2013-14 4.7 4.6 -1.7 10.1 8 2.6 -17.7 9.0 7.81 in per cent of GDP, 2 Average cosumer prices, 3 Repo rate, 4 in months.Source: IMF, RBI and author's calculations.

Figure 1: India Inflation and Interest Rates

CPI

12

10

8

6

4

2

1

10-year bond yield

Policy rate

Core CPI

WPI

1/2012 4/2012 7/2012 10/2012 1/2013 4/2013 7/2013 10/2013 1/2014 4/2014 7/2014 10/2014Source: CSO, RBI and authors calculations.

Shift to inflation targeting

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framework and the macroeconomic con-text noted above provides a perspective on the possible output sacrifi ce associated with these. Critically, the UPC was silent and non-transparent about the output costs of disinfl ation during the transition (glide path) to the medium-term infl a-tion target even as it revisited the choice of nominal anchor; the institutional struc-ture, operating framework and instru-ments of monetary policy; the impedi-ments to its transmission as well as its conduct in a globalised setting. Though it stated that output sacrifi ce was balanced vis--vis the speed of entrenchment of credibility in policy commitment (UPC: Para II.42, p 19) in computing the glide path to the medium-term infl a-tion target of 4% (2% band) in two years time, it did not share the estimat-ed declines in GDP en route.

Notwithstanding this gap, which pre-cludes understanding of the precise out-put gap at the time of the shift, qualitative losses can still reasonably be inferred. Two distinct components of disinfl ation costs can be identifi ed. The fi rst consti-tuent arises from a general defl ationary bias due to increased infl ation-focus. This can be termed as temporary or cyclical contraction in output in the normal course of monetary policy transmission as demand moderates in response. Out-put losses incurred from these forces are recoverable with resumption of the usual business cycle.

The second output loss component occurs from the move to signifi cantly higher consumer price infl ation as nominal anchor from much-lower producer price infl ation. This constitutes a permanent loss of output for it arises from a struc-tural change causing a lasting increase in the real cost of capital to which producer fi rms must adjust over longer period. It represents a permanent cost disadvantage from an enduring interest rate shock whose size is directly measurable: This is equivalent to the consumer-producer infl ation gap, an average 419 bps in Jan-uary 2012-November 2014 (Figure 1). This loss of competitiveness, in conjunc-tion with existing cost disadvantages like poor, inadequate infrastructures, etc, comes at a critically low point of the economic cycle when fi rms are at their

most vulnerable with limited abilities to withstand a shock of this nature. The real output effects will play out and manifest over a longer period, i e, beyond the business cycle, making visible the resultant, permanent decline in GDP as some real investment reallocates; for example, fi rms at the margins may alto-gether be priced out and transfer resour-ces to where relative returns may be higher. Given the larger signifi cance of cost of capital for manufacturing or the tradable sector, the risk here is of a resource-shift towards non-tradables, which would undermine the intended direction of structural adjustments to bring about lasting corrections in the current economic imbalances.

Balance Sheet Distress

The relevance of the macroeconomic context for these transitions becomes more apparent when we look at the severity of the balance sheet distress that the extra-ordinary monetary tightening has no doubt compounded, e g, stressed advances have risen further to 24.2% of overall loans by June 2014. Further, manufac-turing growth in April-October 2014 was just 0.7% over a comparable -0.1% con-traction in 2013; bank credit (non-food) growth of 4.3% in March-November 2014 was nearly half of 2013 is corresponding 7.2%; and the cumulative 75 bps of mone-tary tightening in September 2013-Janu-ary 2014 all but failed to transmit to banks who did not respond to monetary policy signals in this period and are low-ering deposit rates in recent months as loan demand remains very weak.

For manufacturing fi rms to recover from cyclical and structural shocks of this na-ture could take very long, especially in an environment of surplus global capacity across countries. An alternate setting for choice of timing this transition could have been (i) a stronger growth cycle, not necessarily at the peak, but perhaps in the upper region of an upswing; and (ii) reduced consumer-producer price divergence to minimise the size of interest rate shock. If disinfl ation extracts too high a price, the severe output losses in the initial stages of infl ation targeting could increase risks to the next stages of implementation itself as reasoned below.

Supply Side Risks: The Indian political economy context, which must adapt itself for monetary policy support, is essentially non-responsive in that reforms of market structures to allow free, effi cient func-tioning and pricing to balance demand-supply forces have long been half-hearted, delayed and interminably postponed. This raises the risk of an extra ordinary burden upon monetary policy, which could be forced to remain tighter than otherwise would be the case. For, with headline CPI infl ation as nominal anchor, food infl ation is now subsumed under this. As food infl ation directly spills over into a generalised price increase or core infl ation, to which the policy rate is aligned, aggregate demand would have to be kept suffi ciently compressed until some such time that quicker supply reac-tions set in. If supply-side responses are unforthcoming, in conjunction with the low-growth conditions at the time of transition, the economy could be trapped into a vicious circle, breaking out from which could be diffi cult due to a fear of undermining policy credibility. Such a fl exible supply response scenario is presently hard to contemplate in the political economy structure. It could of course also be the case that infl ation targeting, which ties down monetary policy to a certain path failing which credibility is at risk could itself compel such supply-side reforms.

Weak Institutional Framework: A strong institutional support is essential for infl ation targeting. The most funda-mental of this is fi scal support as fi scal policy, due to its close and immediate relationship with aggregate demand, can negate monetary policy effort and poten-tially undermine the most credible of central banks. The risk is especially large in emerging market economies (EMEs) including India, as fi scal dominance is very often a key infl ation driver. The UPC well recognised this, dwelling at large on the fi scal infl uences upon mon-etary policy conduct in India (Chapter 2, Section 3). Recent fi scal history is quite discouraging in this context. Adherence to fi scal rules, critical for transparency, accountability and forward-looking mone-tary policy, is not well entrenched.

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Indeed, the fi scal past is ridden by aban-donment or pause of rules each time the business cycle wanes, growth slows and revenues decline. For instance, a pause was announced in 2009-10 to combat the crisis shock and return to the path laid out under the Fiscal Responsibility and Budget Management Act was delayed. A new fi scal consolidation path was drawn by the Kelkar panel in late-2012 to restore the health of public balances by 2016-17; this was adopted with the government on course to achieve this since last quarter of 2012.

However, history seems set for repeti-tion once more with the current public discourse favouring a pause to the revised fi scal consolidation path for accommo-dating growth concerns: With growth recovery elusive, there is emerging con-sensus and advocacy for fi scal pump-priming: the governments recent Mid-Term Review suggests that public expen-diture replace the private business spend-ing vacuum and kick-start growth; and there is indication that the ongoing fi scal consolidation road map may be revised, modifi ed or replaced to incorporate countercyclical elements. The risk from such political responses to the business cycle in undermining the RBIs credibility as also of the new framework is quite high.

Then again, while institutional support by way of tight fi scal rules would be re-quired in the next stages of FIT, the re-quired fi scal path could be quite demand-ing given current growth conditions and medium-term outlook. This directly brings into focus the macro economic timing of the transition. Unless growth picks up quite substantially to relieve the fi scal burden and relaxes budgetary con-straints, there could be political tempta-tion to delay or breach fi scal targets; or political support for FIT could be weak.

Exchange Rate Fluctuations and the Nominal Anchor: Exchange rate stability is a key element in stabilising CPI infl ation, particularly in EMEs. Exchange rate fl uc-tuations cannot be altogether ignored, especially depreciations that lead to a rise in infl ation from pass-through of higher import prices and greater export demand, besides detrimental effects of dollarised liabilities and vulnerability of

access to international capital markets which endangers fi nancial stability (Mishkin 2004). Infl ation targeting is theoretically inconsistent with reserve accumulation as systematic monetary policy responses to dampen exchange rate fl uctuations are incompatible with price-level stability (Obstfeld 2013). The open economy trilemma in macroeco-nomics proposes a corner solution of full exchange rate fl exibility to allow for capital mobility and monetary policy sovereignty; in reality though, IT-EMEs are observed stabilising exchange rates nonetheless (Fischer 2001). Likewise, the UPC factors in reserve accumulation for intervening in foreign exchange markets. The risk here is of excessive focus upon the exchange rate, transforming it into a nominal anchor preceding the infl ation target. This need not always be the case, but pursuit of two nominal objectives cannot be ruled out, say, in a prolonged capital outfl ow episode.

The second issue is of sterilisation costs. The UPC made clear its preference for a multi-pronged approach in conduct of monetary policy in a globalised envi-ronment with primacy to interest rate response. It highlighted sterilisation of the liquidity impact of reserves accretions as a key monetary policy challenge in this regard, recommending (i) build-up of a sterilisation reserve out of its existing and evolving portfolio of govern-ment securities across maturities, with accent on a strike capability for rapid intervention at the short end; (ii) intro-duction of a remunerated standing deposit facility to empower RBI with unlimited sterilisation capability. The point here is of costs that would devolve upon the public balance sheet, either directly through interest costs borne by the central govern-ment from payouts on higher-yielding domestic securities, or indirectly by way of revenues foregone on account of lowered dividends transferred by the central bank in the latter instance. Both contribute towards an increased fi scal burden.

3 Conclusions

In his consideration whether infl ation targeting can work in emerging market countries, Mishkin (2004) underlines that developing strong fi scal, fi nancial

and monetary institutions is very critical to the success of infl ation targeting in emerging market countries. Examining the Brazilian and Chilean cases, he con-cludes that infl ation targeting is more complicated in emerging market countries and is not really a panacea, but if done right it can be a powerful tool to help promote macroeconomic stability in these countries. As this article reasons, the timing of Indias transition to FIT, viz, an adverse domestic and global macroeconomic context, poses signifi cant risks to a successful implementation. In particular, the possible output sacrifi ce that may be signifi cant could have an impact on the evolution of supportive in-stitutional structures necessary to carry forward and build upon the credibility of the new monetary regime.

The poor, uncertain global environment of the post-crisis period has also cast a shadow of doubt over the pre-crisis evidence on infl ation and output perform-ances under IT-regimes.2 These studies mostly concentrated on the post-1990s, pre-crisis period when many countries adopted IT frameworks. The evidence is overwhelmed by the phase of Great Moderation a time now understood as having been an exceptionally benign eco-nomic environment of low, stable infl a-tion combined with steady economic growth that ended in 2007. The causes of this reduction in macroeconomic vol-atility are still not fully identifi ed, i e, if macroeconomic shocks were simply smaller because of good luck, or if better policies including IT, promoted stable growth and low infl ation, is an unresolved issue. This was also a period of sustained, high Chinese growth rates that sparked a long commodities boom, which fuelled rapid growth in EME commodity-exporters, many of whom shifted to IT at the same time, and which facilitated sharp reductions in net public debt-GDP ratios.

The larger macroeconomic shocks of the post-crisis period have been recently employed to re-examine IT experiences across countries in an aggregate overview by economists from the Bank of Inter-national Settlements (Banerjee, Cecchetti and Hofmann 2013). They fi nd that non-IT EMEs enjoyed faster growth rates of 7.13% on an average in 2000-06 and an average

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4.13% subsequently in 2007-12. On the other hand, IT-EMEs grew more slowly in these two time periods, an average, respec-tive 4.51% and 3.65%. For Indias adop-tion of FIT, the national and internation-al environments could be very critical in the light of these doubts and risks.

Notes

1 Under this approach, a number of quantity variables such as money, credit, output, trade, capital fl ows and fi scal position as well as rate variables such as rates of return in different markets, infl ation rate and exchange rate are analysed for drawing monetary policy perspec-tives. Since the 2000s, these are supplemented with forward-looking indicators drawn from the RBIs surveys of industrial outlook, credit conditions, capacity utilisation, professional forecasters, infl ation expectations and con-sumer confi dence (RBI 2014: 8-9).

2 Comparing the infl ation-output performances in IT-countries before and after adoption of IT with non-IT countries between 1991-2000 and 2001-09, Roger (2010) fi nds that (i) Both IT and non-IT low-income economies experienced

major reductions in infl ation rates and improve-ments in average growth rates; although non-IT countries continued to have lower infl ation and higher growth than IT ones, the latter saw larger improvements in performance. (ii) Both groups also experienced large reductions in in-fl ation-output volatility, but IT-countries regis-tered bigger declines, especially in infl ation volatility. (iii) Among high-income economies, little change in performance occurred in the IT-countries on average in these two periods, whereas the non-IT set typically experienced a decline in growth; likewise, the former group experiences little change in output or infl ation volatility between the two periods, but output volatility was higher in the non-IT group.

References

Banerjee, Ryan, Stephen Cecchetti and Boris Hof-mann (2013): Flexible Infl ation Targeting: Performance and Challenges in Lucrezia Re-ichlin and Richard Baldwin (ed.), Is Infl ation Targeting Dead? Central Banking after the Crisis, Centre for Economic Policy Research: 118-25. http://www.voxeu.org/sites/default/fi les/fi le/P248%20infl ation%20targeting.pdf

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