India’s growth is slumping and inflation has shot above target. Still, the debate remains narrowly focused on whether the Reserve Bank of India (RBI) should cut interest rates or not.
This misses the point. The current predicament underlines failures of the inflation-targeting framework. For growth to have a chance at recovery, inflation targeting needs an overhaul.
The recent surge in inflation is causing much hand-wringing. But India’s experience with inflation targeting, over the past six years, shows excessively low inflation has been a bigger concern, and has cost the economy dearly in terms of lost output. Major drawbacks have been RBI’s conservative bias to overachieve on its inflation target and the choice of headline consumer price index (CPI) inflation as the nominal anchor.
On average, RBI has undershot its inflation targets by an estimated 3.3 percentage points since it first adopted the framework in January 2014.
RBI used to implicitly target wholesale price inflation at around 5%. A shift towards CPI inflation target of 4% in January 2014 meant that RBI no longer cared about the weak pricing power of manufacturing firms. This allowed real interest rates to rise sharply for manufacturing firms, causing a slump in industrial growth.
Additionally, high volatility of headline CPI inflation makes monetary policy prone to errors. The standard deviation of the new CPI inflation series since January 2012 is 2.7%, and over the last two years is 1.2%. This is high, relative to the 2 percentage point buffer on either side of the 4% inflation target.
A minimum 2 standard deviation buffer is needed around the target to account for a 90% confidence interval. Finally, the CPI basket includes fresh crops, gasoline and gold. Prices of these items are largely, though not entirely, influenced by government policies.
Tasking the Monetary Policy Committee (MPC) to target these items also makes it accountable for government actions. This not only clashes with the principle of central bank independence, but has also increased RBI’s conservative bias.
RBI should target the price level based on a fixed inflation rate to overcome this bias on inflation. Additionally, it should choose a nominal price anchor that is sensitive to the structure of the domestic economy and allows greater latitude for its secondary objective of growth.
India’s economic interests would be better served if RBI were to target the price level instead of the inflation rate. This approach — price level targeting —is both forward-looking and backward-looking. It allows policy adjustment to make up for earlier periods of too high or too low inflation to reach an inflation target-based price level.
It could also be understood as targeting average inflation over a period, as opposed to the current practice of targeting expected inflation over the medium term.
In the current circumstances, this approach would require RBI to shift its focus to increasing inflation to make up for excessively low inflation over the past few years. That would require a further reduction in interest rates and give a healthy boost to growth.
Most economies choose headline or core-CPI inflation as the nominal anchor for inflation targeting. But food occupies a much larger weight in the CPI basket in India. As a result, targeting even core-CPI is not a feasible option due to its small weight in the CPI basket of just over 40%.
The US Federal Reserve Bank targets core personal consumption expenditures (PCE), which is based on surveys of what businesses are selling. That balances the interests of both consumers and firms. Additionally, a lower mean inflation for core-PCE, as opposed to core-CPI, allows the Fed more leeway to focus on its secondary objective of growth.
The Czech Republic targets core inflation excluding regulated prices and indirect taxes. Thailand targets core-CPI inflation excluding fresh food and energy prices. In India’s context, targeting similar measures would amount to excluding regulated agricultural crops, gasoline, cooking gas and gold prices.
A combination of core wholesale price index (WPI) and core CPI inflation would be an improvement over RBI currently targeting headline CPI inflation. This would help in balancing the interests of manufacturers and consumers. This measure of inflation also has a low standard deviation and a low mean inflation rate. That should help avoid policy flip-flops and also support RBI’s secondary objective of maximum feasible growth.
The writer is senior economist, Bloomberg Economics