Inflation Targeting Risky Business

It can cause asset bubbles, undue real estate boom, speculative trading of the Indian Rupee and export bust. Things may spiral out of control when international crude oil price shoots up again. The RBI must tread cautiously while the government distributes infrastructure evenly, promote unconventional, eco-friendly and renewable energy sources and export mainly value-added products.

In an unprecedented move, the Reserve Bank of India (RBI) has entered into a pact with the Government of India to maintain inflation (as per the Consumer Price Index, CPI) below 6 per cent for the financial year 2015-16 and between 2 per cent to 6 per cent (4 per cent ± 2 per cent) in the subsequent financial year 2016-17.

The RBI has been working on such a measure for quite some time under a committee headed by Deputy Governor of RBI Urijit Patel. Under the pact with the government, the central bank will be considered to have missed its target if inflation stays above the agreed limit beyond 3 quarters and, in case it misses the target, it will have the responsibility to explain to the finance ministry about causes and steps that it intends to take to bring back the inflation under the agreed level within a stipulated time.

Many rating agencies like Moody’s have appreciated this move and suggested it would improve India’s sovereign rating.

But the development has attracted both positive and negative reactions. This style of fixing Inflation called “flexible inflation targeting” in academic circles is not new in the world; many countries have been doing it for the past few decades. A good amount of academic literature has been published, focussing on the suitability of inflation targeting for the so-called emerging economies like India. [Beldi Amira, Djelassi Mouldi, and Mete Feridun’s “Growth effects of inflation targeting revisited”]

Proponents of inflation targeting argue that such a move will bring about a stable economy with stability of key indicators like inflation and interest rates, and will make the central bank more responsible for the health of the economy. Also, the predictability of inflation brings in transparency and effectiveness of the central bank’s monetary policy. Opponents of this move have given an argument that such a move will not lead to stable growth though it may result in higher growth rates, and there are cases wherein some countries have faced issues like balance of payment crisis and threats like speculative attacks from currency traders. Some have even argued that this is not a prescription for emerging economies at all.

The Indian economy is currently in a sweet spot with low inflation and oil price, decreasing interest rate and fiscal deficit. India has become the fastest growing large economy in the world — thanks to a new method of calculating the GDP — and is poised to move to a higher growth trajectory, which is evident from the Economic Survey that has indicated a possible double-digit GDP growth. At this juncture, low inflation, stable interest rates and reduction in fiscal deficit as targeted by Finance Minister Arun Jaitley will be big boosters for India’s growth as they tend to trigger higher investment by business establishments and higher spending by consumers.

But there are some pitfalls in this approach, which the RBI and government should be cautious about.

– Low interest rates driven by low inflation have caused asset bubbles in many economies. Skyrocketing real estate prices and peaking stock markets are common in such a scenario [Inflation Target Tyranny by John Quiggin]. This would make housing unaffordable for many and turn many businesses unviable. Any mishap in the economy causing increase in the interest rate would end up bursting of the asset bubble, creating huge non-performing assets in financial institutions and slowdown of the economy.

– India’s oil consumption is going up and much of our oil demand is met by imports. Though oil prices have plummeted recently, there is a visible reversal of the trend. A further rise in the international crude price will have a cascading effect on other commodities, fuelling a hike in inflation. There is a possibility that inflation may reach a point beyond control and by then it will have pulled the interest rate high, too, and sucked liquidity in the economy [In an attempt to check inflation, the RBI will then probably increase the repo rate and SLR in its 45 day monetary policy review].

– With stable inflation and interest rate, high growth prospects in the economy, the Indian currency may attract currency traders and speculators all over the world to bet on the Indian Rupee by going long on our currency (buying it or exercising the call options) causing a sudden appreciation of the Rupee over other currencies of the world. This would be detrimental to India’s export-driven industries like information technology, textiles, jewellery etc. Though there are benefits of an appreciating rupee, as it will lower the import bill, this will cause tremors in some sections of the economy. To check the currency’s appreciation, the RBI will then have to get involved in open market operations by selling foreign currencies, which will, in turn, reduce its reserves.

Since growth should be the main purpose of this inflation targeting, the RBI will have to have a revisit its pact with the government in the event of

– oil price going up beyond a certain limit causing high interest rates in an attempt to maintain the inflation levels, as high interest rates typically curb investments and halt growth;

– the interest rate going up due to overheating in the economy caused by high growth

– Indian rupee appreciating beyond a certain limit, causing exports unviable, or

– a real asset bubble emerging, making housing unaffordable.

The RBI has very few options in case of a crisis, but some bold steps from the government can pre-empt the problems one anticipates. To aid the central bank in targeting inflation within the limit, there is a need of action from government on different fronts like

– promoting solar and renewable energy, and encouraging battery-operated vehicles to reduces dependence on petroleum products;

– focussing on infrastructure across the country, preventing the movement of population to a few urban centres, which would fuel asset bubbles, and

– promoting high-end and high-value added exports, which are stable even in a currency shock situation.

In spite of some pitfalls in inflation targeting, it is worth a try as it can push the Indian economy to a best case scenario. The only caveat: It should get support in terms of some bold steps and supportive actions from the government.