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Central bank and inflation targeting

To maintain a good economic health in any country, it is necessary for both the Central bank and the government to work in tandem. However, in India, this has not been the case. There is a growing distrust between RBI and the Finance Ministry.

Few recent developments indicate this:

  • The denial of extension by the government to previous RBI governor despite his willingness to continue. This is only the second instance after economic reforms when an incumbent governor has not got a term of five years.
  • The creation of the monetary policy committee (MPC) also implies a change in the way the policy is designed in the country.

 

Challenges before the new governor:

  • New governor Urjit Patel is expected to deal with the changed policy environment. The popular notion of the central bank and monetary policy as being the primary instrument of inflation targeting is no more relevant in the changing domestic and global environment. This is going to get further exacerbated with the changing financial architecture and the changing nature of inflation and price transmission.
  • Changing economic structure domestically as well as globally also suggests a need for focusing on stabilizing the financial market.
  • The existence of crony capitalism and the corporate-bank nexus will require more than a cleaning up of the balance sheets of banks. But a bigger challenge will be to integrate the rural and informal economies with the financial economy.
  • Also, he has to deal with the issue of bridging the trust deficit between the government and RBI.

 

Background:

It is now widely believed that monetary policy had very little to do with the decline in inflation since 2014. There are few factors which helped keep inflation low in the last two years. These include:

  • Sharp drop in petroleum prices and the accompanying decline in primary commodity prices after August 2014. Metal and mineral prices declined sharply in the last two years and various agricultural commodities also witnessed a sharp fall in prices.
  • The distress in rural areas that had started building up since November 2013 has continued until now. The drying up of demand in the last three years was seen in the decline in real wages in rural areas.
  • There was also a decline in farm business income and a drop in construction and other non-farm activities which had maintained wage rate growth even during periods of drought.
  • The cutback in rural spending, partly a result of the Fourteenth Finance Commission award and partly as a result of the government’s decision to cut back spending on rural programmes, also resulted in low rural demand.
  • Back-to-back droughts in the last two years have added to the misery of the rural population.
  • The continued recession in major markets outside India meant that exports fell throughout the last two years. The net result of weak domestic demand coupled with falling exports was a build-up of inventory and excess capacity in the manufacturing sector.

 

Role of Monetary Policy in Inflation control:

According to experts, while all those factors mentioned above contributed to low inflation that persisted in the last two years, none of these was affected by the RBI’s monetary policy. Nor was monetary policy successful in keeping retail inflation low.

  • While retail inflation has come down as a result of the factors mentioned above, the real problem with inflation in India has been persistently high food inflation. While these have moderated a bit due to distress in the economy, they continue to be beyond acceptable limits.
  • Most of the inflation in food commodities has been due to structural problems of marketing, excessive speculation and flip-flop in government policy, with no role of monetary policy. This continues even today.
  • Hence, it can be said that neither was the high inflation a result of poor monetary policy nor is the decline in inflation a result of monetary policy.

 

What is inflation targeting?

Inflation targeting is a monetary policy in which a central bank has an explicit target inflation rate for the medium term and announces this inflation target to the public. It will have price stability as the main goal of monetary policy.

Many central banks adopted inflation targeting as a pragmatic response to the failure of other monetary policy regimes, such as those that targeted the money supply or the value of the currency in relation to another, presumably stable, currency.

 

Why it is good?

  • It will lead to increased transparency and accountability.
  • Policy will be linked to medium/long term goals, but with some short term flexibility.
  • With inflation targeting in place, people will tend to have low inflation expectations. If there was no inflation target, people could have higher inflation expectations, encouraging workers to demand higher wages and firms to put up prices.
  • It also helps in avoiding boom and bust cycles.
  • If inflation creeps up, then it can cause various economic costs such as uncertainty leading to lower investment, loss of international competitiveness and reduced value of savings. This can also be avoided with targeting.

 

Challenges to inflation targeting:

  • It puts too much weight on inflation relative to other goals. Central Banks Start to Ignore More Pressing Problems.
  • Inflation target reduces “flexibility”. It has the potential to constrain policy in some circumstances in which it would not be desirable to do so.
  • Cost-push inflation may cause a temporary blip in inflation.

 

Way ahead:

Inflation targeting has been successfully practiced in a growing number of countries over the past 20 years, and many more countries are moving toward this framework. Over time, inflation targeting has proven to be a flexible framework that has been resilient in changing circumstances, including during the recent global financial crisis. Individual countries, however, must assess their economies to determine whether inflation targeting is appropriate for them or if it can be tailored to suit their needs. This should not be seen as a panacea for all the problems.

 

Conclusion:

Inflation targets can have various benefits, especially during ‘normal’ economic circumstances. However, the prolonged recession since the credit crunch of 2008 has severely tested the usefulness of inflation targets. There is a danger that Central Banks give too much weighting to low inflation, when there is a much more serious economic and social problem of unemployment. One solution would be to give an equal weighting to an inflation target and output gap target.

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