Why Modi Should Not Have Bought Into Rajan’s Inflation Targeting Idea

One of Prime Minister Narendra Modi’s less memorable observations in his Independence Day speech was his reference to the agreement between the Reserve Bank of India (RBI) and the government to keep inflation in a plus or minus two zone around four percent. Even as he was speaking, retail inflation had already breached that limit.

While it is perfectly all right for a prime minister to assure his people that he will try to keep inflation in check, the focus on the agreement with the RBI makes little sense for the simple reason that the fall in consumer inflation till early 2016 had little to do with what the RBI did or did not do. Nor can its rise now be blamed on the central bank. Central banks are the wrong guardians of inflation.

Raghuram Rajan’s decision to keep interest rates relatively high had almost nothing to do with the fall in the Consumer Prices Index (CPI). In January 2014, when he raised the repo rate to eight percent (the recent peak), CPI inflation, then 8.6 percent, was already beginning to fall. When the government and the RBI signed their inflation targeting agreement in March 2015, CPI inflation was already heading towards five percent. So, the deal to target inflation was signed after the target was achieved.

On the other hand, it is more than clear that food prices (and sometimes fuel) are key drivers of inflation. As Sajjid Chinoy argued in this Mint article, inflation fell when food prices started levelling off. Chinoy wrote in August 2015:

To be sure, MSPs often depend on signals in global food prices, but the link between government decisions on MSP and inflation is more direct. In short, what happens to CPI inflation depends a lot on what the government does than what the RBI does.

The failure of inflation targeting is nowhere more stark than in the west, where for eight years central banks have been targeting inflation with near zero interest rates and still have not managed to hit it.

The problem with using monetary policy to target inflation is doubly wrong because the inflation we measure is the one involving traded goods and services. On the other hand, interest rates tend to impact asset prices more, and the biggest beneficiaries of near zero rates were not ordinary businesses, but Wall Street. Stocks hit new highs even as the US economy was stuck in low orbit or heading south.

A related reason to avoid inflation targeting is that it aids speculation and not the real economy.

When central bankers announce that they are going to target a particular rate of inflation, speculators and hedge funds take bets based on this assurance. Today, for example, with July inflation hitting the upper band of six percent, all punters know that the RBI is unlikely to cut rates in the near future; if they find the rate rising, they will start punting on the rupee’s direction, or rate-sensitive stocks. If growth plummets, should the RBI be keeping rates high or reducing them?

Now consider what would have happened in 2008, when inflation was high and the Lehman crisis had crashed the global economy. What would have happened if the RBI, instead of cutting rates to stabilise sentiments, went ahead and kept rates high? At that point, cutting rates helped us avoid a crash. Tomorrow, if the CPI rate is above six percent and the world falls into another 2008-like scenario, should we still keep rates high? We would be foolish to do so.

When CPI data comes with a lag, should the RBI look at what is happening now or what happened two months ago?

The short point is this: it is good to use interest rates to signal the central bank’s best guesses about inflation trends, but trying to target an inflation rate when there are so many factors affecting it makes no sense.

Using rates to target inflation is like using a badminton racket to hit a cricket ball. It will only expose the lack of central bank firepower when needed.

To be effective, central banks should not say they will use only interest rates, but many more instruments, including physical controls, at moments of crisis.

Even then, it is governments, which have the bazookas to deal with crises. Bazookas like price hikes (or cuts) in regulated sectors. Trimming (or expanding) fiscal deficits. Specific targeting of subsidies or taxes on people, companies and products. In the worst case scenario, governments can simply devalue or upvalue the currency to kill inflation.

Inflation targeting is fine as a stated public objective, but cannot be the main goal of a central bank. (For a strong critique of inflation targeting, read this Swarajya article here).

Modi should not have bought into this flawed logic.