Inflation targeting will only work if govt keeps its end of bargain

Mar 5, 2015

- By Vivek Kaul

Vivek Kaul
The finance minister Arun Jaitley's budget was slightly high on the policy front. One of the things that Jaitley announced in the budget was: "To ensure that our victory over inflation is institutionalized and hence continues, we have concluded a Monetary Policy Framework Agreement with the RBI...This Framework clearly states the objective of keeping inflation below 6%. We will move to amend the RBI Act this year, to provide for a Monetary Policy Committee."

This strategy essentially involves a central bank estimating and projecting an inflation target, which may or may not be made public, and then using interest rates and other monetary tools to steer the economy toward the projected inflation target.

In the Indian case the target has been made public. As per the agreement between the Reserve Bank of India(RBI) and the government, the RBI will aim to bring down inflation below 6% by January 2016. From 2016-2017 onwards, the rate of inflation will have to be between 2% and 6%.

One of the popular theories going around(especially in the social media among Narendra Modi bhakts) is that by doing this the government has managed to clip the wings of the RBI governor Raghuram Rajan.

--- Advertisement ---
Small Caps Could Make A Big SPLASH... Literally!

Investing in small caps has at times doubled and even tripled the investments of a select group of investors.

How did they do it?

Well, by knowing two simple facts -- which small stocks to invest in, and when to invest in them.

That knowledge has given them amazing returns like 177% in 2 years, 217% in 3 years and 11 months, 250% in 2 years and 1 month... and more.

Click here to know how YOU too could become privy to that knowledge... and potentially make those kind of returns.
---------------------------


Nothing can be far from truth as this. Rajan has been an active advocate of central banks following inflation targeting as a strategy, over the years. He believes that the RBI should be concentrating on controlling inflation, instead of trying to do too many things at the same time.

As Rajan wrote in a 2008 article (along with Eswar Prasad): "The central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act."

By trying to do too many things at the same time, RBI ends up being neither here nor there, the RBI governor feels. As Rajan and Prasad put it: "What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well."

Hence, Rajan felt that the RBI should focus on controlling inflation. As he wrote in the 2008 Report of the Committee on Financial Sector Reforms: "The RBI can best serve the cause of growth by focusing on controlling inflation."

The agreement chalked out by the government and the RBI is in line with the recommendations of the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel committee report) which was released in January 2014. The Committee had recommended that the RBI be set an inflation target of 4%, with a band of +/- 2 per cent around it.

Also, the way the RBI is currently structured, it is another remnant of the British Raj. World over central banks are essentially run by monetary policy committees. In India setting the interest rate is the personal responsibility of the RBI governor. This should change with Jaitley saying that the RBI Act will be amended to put a monetary policy committee in place, this year. From the point of view transparency and clear goal setting this is a good move.

Nevertheless, the question though is, is inflation targeting the right strategy to follow? First and foremost, the agreement between the government and the RBI is about maintaining inflation as measured by the consumer price index(CPI) between 2% and 6%, starting in 2016-2017. Before this, the RBI needs to ensure that inflation stays below 6%.

Every six months, the RBI is supposed to publish a document which explains the sources of inflation and forecasts inflation for a period of six to eighteen months from the date of publication of the document.

The thing is that food and beverages constitute 54.18% of the CPI. Food inflation in India is typically caused by disruptions in supply (majorly due to the weather). Take the recent case of rains hitting North India. This has had a dramatic impact on vegetable supply in New Delhi, and led to higher prices.

The RBI cannot do anything in a situation like this. Further, the government policy of the day also has a huge impact in determining which way the food prices go. The government through the Food Corporation of India(FCI) buys wheat and rice at minimum support prices (MSPs). The previous Congress led United Progressive Alliance(UPA) government increased the MSP of rice and wheat dramatically over the years, which in turn led to higher food prices.

As the Economic Survey released a day before the budget points out: "High MSPs result in farmers over-cultivating rice and wheat, which the Food Corporation of India then purchases and houses at great cost. High MSPs also encourage under-cultivation of non-MSP supported crops. The resultant supply-demand mismatch raises prices of non-MSP supported crops and makes them more volatile. This contributes to food price inflation that disproportionately hurts poor households who tend to have uncertain income streams and lack the assets to weather economic shocks."

This is something that the RBI has no control over. And in situations like these, monetary policy is more or less useless.

What this also means is that the RBI alone cannot ensure that inflation stays less than 6% (or between 2-6% from 2016-2017 onward). The government will also have to follow a responsible fiscal policy. Getting the RBI to sign to an agreement of maintaining low inflation clearly does not mean that only the RBI is responsible for inflation and the government can do whatever it wants to on the fiscal front.

As Rajan said in the monetary policy statement released yesterday: "The central government has signed a memorandum with the Reserve Bank setting out clear inflation objectives for the latter. This makes explicit what was implicit before - that the government and the Reserve Bank have common objectives and that fiscal and monetary policy will work in a complementary way." I hope, the government keeps its end of the bargain.

Postscript: The RBI cut the repo rate yesterday by 25 basis points (one basis point is one hundredth of a percentage) to 7.5%. Honestly, I was not expecting this and I had more or less said so in the column that appeared on March 2, 2015.

One thing the rate cut tells us is that Rajan hasn't bought into the new GDP growth number of 8.1-8.5% in 2015-2016. Jaitley had talked about India soon hitting double digit economic growth in his speech.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

Recent Articles

Get 'India's Big Government' at Just Rs 199 Now October 18, 2017
Vivek's latest book is now available at a rare discount. Grab a copy now.
Our Plan to Save the Ranch October 18, 2017
How to increase fertility in the kingdom of cows.
Nobody Honks in Bali - Lessons for Indian Tourism October 17, 2017
Things India can learn to promote tourism from this small island.
We Rode Out... Unarmed October 17, 2017
Money is the tape measure for the carpenter economy.

Equitymaster requests your view! Post a comment on "Inflation targeting will only work if govt keeps its end of bargain". Click here!

1 Responses to "Inflation targeting will only work if govt keeps its end of bargain"

vinod bajaj

Mar 5, 2015

Currently these rate cuts are not doing much for common man / senior citizens.
Negatives:1. Bank FD rates are heading south reducing incomes 2. Senior citizens and bulk of population is not loan dependent. 3 Everytime a rate cut is suddenly announced the sensex moves up. this is huge opportunity for people in the inner circle as common man is not an investor.Dont see many positives except corporates. they are not going to pass on their profits. similarly the private sector banks are not passing on profits thhey are making from the rate cuts.

Like (2)
  
Equitymaster requests your view! Post a comment on "Inflation targeting will only work if govt keeps its end of bargain". Click here!