03 April 2017 09:30:53 IST

An overdose of inflation targeting

By taking an exaggerated view of external price and output shocks, monetary policy has stifled demand

The inflation bias is well known in macroeconomics as the temptation for policymakers to create excess inflation to stimulate output. Inflation targeting is designed to counter the temptation. But it can create the opposite bias.

If bureaucrats are given an inflation target which measures their performance, they would tend to impose too high an output sacrifice in order to achieve their target. Flexible inflation targeting builds in some counters to this bureaucratic bias. For example, it gives a weight to growth, allows some time to achieve the target, and brings in outside experts with independent views in a monetary policy committee.

But there is evidence that these checks have proved inadequate in India, and therefore need to be strengthened.

Wrong inflation expectations

Repeated research at the Reserve Bank of India itself, has shown the importance of food prices for Indian inflation and for household inflation expectations. It has also shown excess capacity in industry. Yet as in classic strict inflation targeting, authorities seek to reduce inflation by further widening a negative output gap. In order to suppress demand, the real interest rate has to be kept high, with the nominal interest rate exceeding expected inflation. A higher future expected inflation rate then allows policy rates to be high even though current inflation falls. But inflation targeting is also about guiding expectations of inflation. If the announced rate of inflation is kept higher, it prevents inflation expectations from falling as much as they could have otherwise.

The bimonthly monetary policy statements from 2014-16 show the one year-ahead inflation announced was almost always about 1 cent above realised inflation. The expected inflation path depicted was always U-shaped or flat, with inflation rising eventually, even if it fell in the short term.

Since from 2014, on IMF advice, a positive natural rate of 1.25-1.75 per cent was built in, it meant real interest rates were actually higher in the contractionary range of 2.25-2.75, discouraging investment that could have reduced supply-side bottlenecks. The IMF ignored first-hand experience of the ill effects of high interest rates on indebted firms during the East Asian currency and financial crisis.

Thus an incorrect emphasis on the weak output gap channel reduces the effectiveness of the expectation channel. This is unfortunate since in Indian conditions the latter is almost the only one that works. A valuable signal that could anchor inflation expectations was not optimally used.

Bias shows in other ways also — for example, the decision to target headline CPI inflation, which was the highest when inflation targeting began, but the shift in policy statements to core inflation when the latter was higher.

There are asymmetric responses such as not reducing rates for a negative output gap but getting ready to raise them when it is thought to be closing. Also an oil price fall is regarded as temporary and a rise as more likely to be persistent. Therefore interest rates are not cut with a fall in oil prices, but there is instant readiness to raise with a rise.

One reason for the bias is a strong pro-market monetarist perspective, itself dictated by pressures from foreign capital. In this view structural reforms create growth, while money supply affects only inflation. If structural rather than macroeconomic policies are seen as affecting capacity, it is inconsistent to believe capacity is likely to be destroyed by lack of use following weak demand. Yet this is articulated as a reason to expect inflationary pressure.

Exaggerated fears

While it is too early to compare the forecasts the MPC makes vis-a-vis realised inflation, there is the same communication that future inflation is expected to rise. Some of the arguments given to support this are weak. For example, firstly, that core inflation is sticky. But it fell sharply in 2014 from 8 per cent to 4 per cent along with a fall in household inflation expectations. It follows that these, built into wages, affect core inflation, not excess demand for services due to shortages of skills. The perception of absence of change is itself a bias.

Secondly, there is the argument that agricultural wages are rising. But the current low rate of increase can be absorbed by productivity increases. It is only the double-digit type rise of 2011, following double-digit food inflation, that causes inflation. Thirdly, there is a fear of oil price rise, outflows and rupee depreciation.

But oil prices are softening again. US shale production can kick in quickly and cap price rise, while some rise in oil prices is good for our exports. Fourthly, inflows and the rupee have strengthened despite a rise in US fed rates. Indian political stability and growth prospects continue to be the primary drivers of inflows, not the interest rate differential. While the Technical Advisory Committee had a healthy diversity of views, the MPC has too much consensus pointing towards bureaucratic dominance.

Cost of bias

High interest rates following inflation targeting reduced demand. Industrial growth, employment, capacity utilisation and investment have been low since 2011. Bank credit to industry and private investment growth actually became negative in 2017. Corporate debt grew at double digits from 2012 raising the share of chronically stressed firms while gross NPAs of PSBs doubled. Five years is too long to suffer to build an elusive future.

Even so, the focus on structural reform and on the long run did successfully reduce vulnerabilities, such as twin deficits. Macroeconomic policy should now be in a position of strength. But unfortunately it continues to overestimate foreign shocks and underestimate its own strengths and capability to smooth shocks, resulting in external dominance and suppression of domestic demand. This although the experience of the 2013 US taper showed raising interest rates to keep foreign capital does not work in India. Even at a vulnerable time, other more effective weapons were found against outflows.

An additional check could be for the RBI governor to report periodically to a parliamentary committee, as in the US, answering informed questions on the inflation target path and its costs.

(The writer is a professor of economics at IGIDR, Mumbai. The article first appeared in The Hindu BusinessLine.)