Is inflation-targeting the way to go?

Jan 28 2014, 05:30 IST
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SummaryDespite its projected benefits in devising monetary policy, inflation-targeting may yield the desired results only with the required supporting fiscal policy measures

The Urjit Patel committee recommendations on inflation-targeting are a bold attempt. The arguments for recommending CPI as a nominal anchor and setting a 2-6% CPI target in the medium term are welcome, and can be seen as a sincere endeavour against the backdrop of a stubborn inflation since FY11. However, in the contours of a developing country like India, the success of inflation-targeting may remain elusive.

In the aftermath of the financial crisis, the focus of central banks has shifted to financial stability instead of inflation-targeting. The US Fed adopted unemployment as a secondary objective underlying the concerns to growing unemployment situation. Bank of England advocated use of nominal GDP as a target; Bank of Japan’s monetary policy statement advocates targeting a higher rate of inflation.

This apart, though inflation-targeting has benefits like reducing the time-inconsistency problem of monetary policy, enhancing the credibility of a central bank and anchoring inflation expectations, offering more flexibility, the empirical evidence of its impact on inflation performance is ambiguous.

One of the justifications in the Patel committee of targeting retail inflation is the fact that countries like Indonesia and Brazil—that have a relatively significant fraction of food and fuel in the CPI basket (close to 40%)—chose to target headline CPI. Within the BRICS (excluding China and Russia), South Africa and Brazil target inflation but do have a higher consumer debt-to-GDP, an essential prerequisite for enabling transmission mechanism (ditto for Indonesia). Even China, that is not doing inflation-targeting, has a household leverage ratio at 32%! In India, the household leverage is 10% at macro level. In the UK, mortgage interest payments have been included as an item in CPI through a rigorous modelling exercise to make the transmission mechanism more effective (absent in India).

The report points out that the level of CPI-combined inflation above which it is inimically harmful to growth is 6.2%. If we take this as the threshold rate of inflation and juxtapose this with a 4% CPI target, it implies that the recommendations may have a built-in bias of being deflationary. By this logic, the band could have been built around a mean of 5-6%, with the deviations centred around such a mean. The 4% CPI target may also imply a WPI at 1.5% (the average CPI-WPI gap has been 2.5% and above), which assumes core WPI and CPI numbers at historic lows.

The committee has made recommendations regarding the constitution of a separate MPC to

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