Targeting Inflation Right: Financial Express 7th May 2007

Targeting inflation right
The RBI has added a new dimension to inflation. The usual 5-5.5% inflation rate which has been targeted in almost all monetary policy announcements has come down to 5% for FY08, and, more importantly, is to be contained at 4-4.5% in the medium run. This has been briefly justified on grounds of India being well integrated with the global economy, and there being a pressing need to pursue the goal of lower inflation. Is this a good idea?
Having a medium-term goal is an excellent thought especially when it is monetary policy as market participants are able to plan accordingly. The predictability of policy based on targeted inflation would guarantee an optimal solution. In fact, this is the stance taken by the Rational Expectations School where its proponents Lucas and Sarjent had argued that policies need to be known in advance for equilibrium. Such an approach may be viewed more as a reverse-rules policy advocated by Friedman and Phelps. Under a “Rules” approach, monetary authorities announce a monetary rate, say money supply growth, which they feel is consistent with an unemployment rate. Any excess monetary expansion is only inflationary. Here we are targeting inflation instead which has implicitly embedded monetary numbers.
But this policy needs to be credible and the RBI should not do a volte-face during this period and go in for a different target. This is so because the market would perceive that in order to reach an inflation number of 4-4.5%, the RBI would tinker with the CRR and repo rates accordingly. Hence, if inflation was reigning high, then logically, the RBI could be expected to come up with upward revisions. The converse would hold in case of low inflation.
Accepting that a medium-term inflation rate is desirable, the issue to be posed is what should be the ideal number. The inflation target should be viewed in the context of overall growth taking place in the economy. Historically, it has been observed that fast growing nations over a time horizon of over a decade do confront a trade-off of high growth and inflation a la the classical Phillips curve. Therefore, if we are looking at GDP growth numbers of over 10% in the next five years or so, we should be prepared for inflation rates of 6-7%. This was the case with the East Asian nations when they registered their trademark as the ‘Asian tigers’, when growth came with inflation. If this picture were to be replicated in India, then targeting a lower inflation rate of 4-4.5% would necessarily mean monetary intervention when the rate rises. This can act as a deterrent to investment and growth.
Prima facie, it appears that when the RBI is looking at an inflation rate of 4-4.5% in the medium run, which one presumes is around five years, then either the implicit assumption is a stable growth rate of around 8-9% or that the target will be susceptible to change if growth rises. It appears that a target of 5-6% would have been more pragmatic as supply imbalances would always typify growing economies which will necessitate regulatory interventions.
Now assuming that the number of 4-4.5% is targeted, is it likely that it will be met? Here there is need to understand the components of inflation and the ones which can be targeted by the RBI.
Inflation, as denoted by the WPI, has three components: primary, fuel products and manufactured products. The prices of primary products with a weight of 22% in the WPI move in accordance with the harvests, and hence are out of the purview of monetary policy. Fuel products, with a share of 14%, are guided entirely by government action, which includes the levels of administered prices as well as fiscal levies in the form of changes in excise and customs duties. Therefore, once again the RBI really has little control over price movements. The manufactured goods segment is the one which typically contributes to demand-pull inflation and where curbs in growth in money supply have a role to play. Excess money supply through growth in credit would feed into higher demand for consumer durables, vehicles, housing and so on. Therefore, only 64% of the commodities which contribute to inflation can theoretically be controlled by monetary policy.
Interestingly, the contribution of primary and fuel articles to inflation in the last two years was as high as 70% and 45% respectively, which really means that monetary policy measures had limited impact in these years. Against this background it could just be that the market could see tightening of monetary policy at a time when inflation is on the supply side, which in turn does not bring forth any response from the RBI. Therefore, the RBI needs to do a periodic inflation analysis.
Thus, having a medium-term goal of inflation is a wise idea, provided the RBI gives up its discretionary power to change the direction of monetary policy as it would be destabilising. The rate of 4-4.5% sounds idealistic and an inflation target of 5-6% would have been more pragmatic. Lastly, periodic inflation reviews by the RBI would be essential given that the market would be depending on this number to foresee RBI action, which may not be needed especially if inflation is not caused by monetary factors.