Column: Inflation-targetting is critical

Nov 25 2013, 08:46 IST
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SummaryCountries with explicit inflation-targetting have a better inflation record than those that lack such a framework

After some months of a falling WPI-based inflation, the numbers have picked up again. Food inflation has risen, but the full pass-through of a depreciated exchange rate is yet to be seen and may push up non-food WPI inflation as well in the coming months. The Indian inflation story can, at best, be summarised as one where the monetary policy stance has failed to anchor inflation expectations in the economy. Among the main problems have been Reserve Bank of India's multiplicity of goals, instruments, lack of transparency in monetary policy strategy, and poor communication efforts. Looking forward, an effective strategy to combat inflation depends on a public announcement of the medium-term numerical inflation target, a clearly articulated commitment to price stability as the sole target of monetary policy, a well-espoused instrument of monetary policy, and an accountability (to the Indian public) mechanism.

One way to move ahead is to keep the framework informal, where RBI chooses to do the above depending on the willingness and the political clout of its Governor, which Raghuram Rajan is, no doubt, well-placed to do. The other is to enact it as law. Most inflation targeting countries include the objectives of monetary policy in the law. This helps to build credibility of the framework and create channels of accountability. Despite similar monetary and fiscal environments, evidence suggests that those who have clear inflation-targeting regimes are better able to achieve low and stable inflation than those who do not have an explicit inflation-targeting framework in place.

February 2006 onwards, inflation breached the upper bound of 5%. It has never come back to the below-5% levels. If our informal goal was to get inflation between 4% and 5%, we have failed to do this as measured by average inflation from 1999 onwards.

Undoing the benign inflationary environment till December 2007, the global commodity prices environment drove prices upwards across all emerging market economies, including India. However, India has been singled out for the speed with which present inflation feeds into its inflation expectations. In other words, it is likely that economic activity will incorporate present inflation as one that will persist into the future, thereby delivering high inflation in the future as well.

The question of anchoring inflationary expectations depends on two critical factors: the magnitude and timeliness of response to prevailing inflationary conditions. Has RBI done enough to anchor inflation expectations? To explain this, Riccardo Christadoro and Giovanni Veronese of

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