Column: At what cost to growth?

Mar 25 2014, 00:54 IST
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SummaryEmerging market experience suggests possible output losses from disinflation under inflation-targeting

The Urjit Patel committee report to revise and strengthen India’s current monetary policy framework recommends a shift to inflation-targeting (IT). It is felt that an IT regime, in which inflation becomes the predominant objective, will make monetary policy more transparent and predictable. It presents a two-year period of disinflation ending in the formal adoption of IT with a 4% CPI inflation target and a 2% deviation band on either side. The transition path to this target zone is graduated to lower inflation from its 10% levels to 8% in the first year, followed by a two-point reduction to 6% the year after. An informal transition began this January with RBI’s adoption of CPI as nominal anchor and policy rate adjustment towards achieving an 8% target in the next 12 months.

Our concern is with the costs of disinflation should the Patel committee’s proposals be accepted. The case for IT rests on two academic insights: Friedman’s claim that there is no long-run trade-off between inflation and growth; there may be a short-run trade-off where higher growth can be obtained with higher inflation as the cost, but the two are independent in the long-run. Since output is beyond the control of central bankers, they should focus on what they can, i.e. inflation. Because a short-term inflation-growth trade-off may tempt a central bank to occasionally favour growth (Kydland-Prescott’s dynamic inconsistency), an IT regime seeks institutional structures binding central banks to commit to a low inflation target acceptable to the public. Once a belief that inflation will remain low is established, public confidence that the medium-run inflation outlook will not change much even when shocks occur will follow. IT works through a stable, predictable link between the policy rate and the inflation rate, with ‘rule-based’ monetary action (Taylor rule).

Thus, growth and employment matter in IT only to the extent that a commitment to a medium-term inflation objective remains credible. The weights on inflation are larger and increased vis-à-vis those on growth in IT. Building credibility by successfully meeting pre-announced inflation targets requires greater effort in the early stages if the credibility bonus—viz well-anchored inflation expectations that then allow some wiggle room to temporarily breach/increase inflation targets without realising actual inflation—is to be reaped later. So, even though operationally IT works more flexibly as ‘constrained-discretion’ than a strict rule, potential disinflation costs in terms of growth sacrifice due to stronger interest rate responses under an IT

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