Excerpts from a good article on Inflation targeting (IT) policy of RBI
There is greater recognition that Inflation targeting (IT) often tends to foster long-term imbalances in debt, leverage, asset prices and exchange rates, making the economy more financially fragile. Fragility leads to financial crises and perversely undermines inflation targeting.
There are a number of reasons why IT is especially unsuited to India. Policy that aims to balance economic growth, financial stability, exchange rate stability, and inflation—not very different from what the RBI practiced—is more likely to deliver moderate inflation over the long haul than targeting inflation directly.
Finance minister R Venkatraman presenting his 1980-81 budget called for coordinated supply and demand measures to find a durable solution to inflation.
It is easy to conduct policy with the benefit of hindsight, but the lesson here is that a mere focus on inflation is not enough—many other indicators need to be monitored. Inflation, like fever, is a symptom of underlying problems and the fever is often a lagging indicator of the problem.
The Fed and the Bank of Japan were among the last developed countries to adopt IT in 2012 and 2013 respectively. Interestingly, both of them adopted IT not because inflation was high but because they were worried about low inflation and entrenched deflation, respectively.
The fact that most periods of high inflation in India are related to monsoon shortfalls or global commodity prices (chart below) should tell you that the problem lies elsewhere and inflation is a symptom not the cause. It is worth noting that South Korea, during its boom in the 1960s and 70s, generally experienced double-digit inflation.
There is very little evidence that interest rates have a significant influence on capital spending. I am not aware of any study related to India, but research has shown that internal hurdle rates at firms in the US have remained remarkably stable at around 15 percent for decades. Given high hurdle rates, targeting low inflation means that nominal growth will be low and fewer projects will overcome the hurdle rate. Thus, low inflation may actually hurt investment, and a casual perusal of data suggests that this might well be the case.
If inflation hurts the poor, weak growth hurts them much more (see the second chart below). In the short term, fighting inflation hurts growth and is likely to hurt the poor. Ultimately, if we want to mitigate the adverse impact of inflation on the poor, policy needs to address food supply and distribution instead of focusing on inflation fighting.
It is well known that India, like many other developing countries, is subject to large shocks to supply (such as drought) and terms-of-trade (that is, our export prices rise less than our import prices). Under such circumstances, recent research shows that inflation targeting is not the best policy. Under IT, the central bank is supposed to let the exchange rate float and not intervene. Left to market forces, developing countries will experience large exchange rate moves. Given that capital flows into emerging markets when times are good and flows out when times are bad, exchange rate moves will tend to amplify domestic financial excesses in good times and exacerbate financial instability during economic downturns.
“But the current crisis has demonstrated vividly that price stability is not sufficient for economic stability more generally. Low and stable inflation did not prevent a banking crisis. Did the single-minded pursuit of consumer price stability allow a disaster to unfold? Would it have been better to accept sustained periods of below or above target inflation in order to prevent the build up of imbalances in the financial system? Is there, in other words, sometimes a trade-off between price stability and financial stability?” — Mervyn King, former Bank of England governor, October 2012.
There has been greater recognition that IT often leads central bankers to ignore buildup in financial imbalances. So, even the ardent supporters have argued for a flexible IT that includes consideration of financial imbalances. Piti Disyatat of the Bank of Thailand has argued that even a flexible IT may not be enough, there needs to be an explicit targeting of financial imbalances as well. Indeed, the RBI in its multiple objectives always kept an eye on financial imbalances.
In adopting inflation targeting, India may have discarded a robust and serviceable framework for a dubious one.