The Urjit Patel report comes as the economy is going through a difficult time. It develops an excellent framework for liquidity management. But over-reacting to recent experience, as it does, isn’t a good way to design a framework. Its argument for choosing a strict headline CPI inflation-based nominal anchor is that it is necessary to anchor household inflationary expectations. But its own empirical exercise shows food inflation to have the greatest effect on household expectations.
Despite monetary tightening reducing growth with little effect on inflation over the past few years, the argument seems to be we must do more of what has not worked. So, a strict focus on inflation is asked for to rescue the RBI from considering growth at all.
The report admits that worldwide, inflation-targeting central banks implement flexible inflation-targeting with weight given to output gaps and unemployment, and post-crisis also to financial stability. But the argument seems to be since large output gaps do not seem to affect inflation, they can be allowed to widen further!
The New Keynesian (NKE) framework is used to justify inflation-targeting, but the presentation of that framework does not discuss its analysis of supply shocks. NKE models show that under forward-looking behaviour, there is no output cost of monetary tightening if demand is in excess.
But policy has to choose the trade-off between current growth and inflation under supply shocks. In the report’s view, there is no growth-inflation trade-off, and inflation is hurting growth. But analysis of the trade-off has to include supply shocks in Indian conditions. These raise inflation while growth falls under conventional tightening. Policy that reduces inflation expectations yet maintains demand is required – e.g., supply-side measures to reduce food inflation.
But if there are multiple supply shocks, a subtler response is feasible. The key requirement is to improve coordination between government and the RBI, since what the government does raises food inflation and what the RBI does hurts industry and employment. Instead, the report has a long wishlist for the government, which has to refrain from any kind of wage-price-interest rate fixing to help the impact of RBI policy rates.
The report is sensitive to the financial sector. Inflation-targeting will make policy more transparent. Other measures on liquidity management can deepen markets and improve transmission of policy rates. But there is no analysis of transmission to the real sector. If the policy rationale is to anchor expectations, there should be estimation of how inflation expectations affect price and wage setting.
The report justifies raising the policy rate above a volatile headline inflation target as this is the inflation most visible to households. But since severe external shocks have buffeted the economy over the past year, the report can’t ignore these. So, it asks for a flexible set of interventions to deal with such shocks. But then, it is inconsistent because the simplicity that was to anchor household expectations is lost. Then why is flexibility not possible for other types of supply shocks?
Even in the event of an external shock, markets reign supreme. First preference is to be given to the interest rate defence, in order to synchronise market expectations with the RBI. This, even though the interest rate defence did not work last year, hurt both the real and the domestic financial sector, increased fragility and is not applicable in Indian conditions where equity flows dominate debt flows. What worked were the swaps with oil companies and banks.
Flexibilities given in a gradual glide path to reduce inflation are taken away, by asking that the real policy rate must always be positive, without the smoothing central banks worldwide practise. This is not warranted in India where interest-rate spreads are high and forward-looking behaviour is not extensive. Loan rates are much higher than policy rates. Some commodity price spikes can be very large but temporary. As these are followed with a blind nominal anchor, interest rate spikes can hurt already fragile banks and firms. This happened after the east Asian crisis.
Flexible inflation-forecast targeting would be a good via media in Indian conditions, since it would allow consideration to be paid to multiple indicators, as is the practice, but communicate a stronger inflation target.
There will be leeway for administered prices the RBI cannot control. The shocks and rigidities the economy is subject to require flexibilities to deal with. The report, instead, asks for a hammer. But extreme solutions are often dangerous.
(The writer is professor, IGIDR)