The first five years of the flexible inflation targeting (FIT) in India is being completed by March 31, 2021. The Government, in consultation with the RBI, has to reset the inflation target for the next five years. The old debate has started once again whether the FIT is suitable for India. Besides marginal tweaking of the inflation target, extreme views are also floating around. While the former RBI Governor, Raghuram Rajan favours status quo on the new monetary policy framework, many old-timers argue that single-minded attention on inflation targeting is harmful to growth. They believe that the FIT has led to a policy-induced growth slowdown in India much before the outbreak of Covid-19.
According to the group of experts who suggest dumping of the FIT, the RBI has the least control over the prices of two major components of the CPI – ‘food and beverage’ (weight 46.86%) and ‘fuel group’ (weight 6.84%) with their combined weights of about 54%. If the weights of petrol and diesel, included in the ‘transport and communication’ (weight 2.3%), are added, the combined weights shall be 56%. While the demand for these goods is price inelastic, their prices are predominantly determined by domestic and overseas supply situation respectively. Assigning 4% headline CPI inflation as an overriding objective of monetary policy with a band of +/-2% harms growth as demand management does not work effectively in influencing prices of 56% of the CPI basket. Sticking to the headline inflation target may unduly neglect growth objective notwithstanding flexibility inbuilt within +/-2% band around the central inflation target of 4%. Globally, none of the inflation targeting countries face the challenge of such a large weight of food group in their CPI basket.
The above argument can be contested in a number of ways. First, under the FIT, the growth objective is not completely ignored although containing inflation is the overriding objective of monetary policy when inflation expectations are outside the RBI’s comfort zone. Second, the adverse supply shocks are generally temporary, unless there are repeated supply shocks. Third, price pressures arising from transient supply shocks are often generalized if monetary policy remains accommodative for a longer period. Fourth, empirical research in India shows that the threshold level of inflation is around 6%, beyond which it harms growth. Accordingly, the upper tolerance limit of the CPI inflation is set at 6% in India. Fifth, inflation harms the poor people most as the social security system in India is not robust. Sixth, targeting core inflation – inflation excluding food and fuel prices – is not a good option as none of the inflation targeting countries targets core inflation. Seventh, inflation targeting in India was adopted by amending the RBI Act when weights of food and fuel groups in the CPI basket were known and therefore cannot be a new argument against the FIT.
The RBI has successfully delivered on the inflation front as the average CPI inflation was 4% during the first four years of inflation targeting i.e., from FY17 to FY20 while it was nearly 7% in FY21 (up to November 2020). The RBI not successful on the inflation front in FY21 is understandable. It was exceptionally an unusual year due to unprecedented disruption in the supply chain following lockdown in the wake of the outbreak of Covid-19. Within the FIT, the RBI could do heavy lifting to manage the crisis and support growth by tolerating the CPI inflation above the maximum limit for about a year under the expectation that inflationary pressures will abate in 2021-22. Exiting from the FIT or tweaking it drastically would adversely affect the central bank’s inflation-fighting credibility.
A group of influential experts continues to argue that the success of the FIT in India was more due to ‘good luck’ than due to ‘good policy’. It is true that the global crude oil prices remained reasonably benign after the global financial crisis, while domestic supply of food items was bountiful during the last several years due to favourable monsoon. Even if good luck played a critical role in controlling domestic prices, it would be unfair if no credit is given to the good policy pursued by the RBI/government through demand and supply management in India. Several empirical studies have shown that good policies did contribute significantly to price stability in India since 2016.
In the near-term, there is no serious external threat to domestic inflation as international crude oil prices are expected to remain benign due to the availability of substitutes, concern about the environment, and weak global recovery. In case of a temporary surge in crude oil prices, both central and state governments have the leeway to reduce excise duties on petroleum products as a part of supply management and thereby complement RBI’s endeavour to control pieces.
The CPI inflation in India is often criticised as an inappropriate measure of true inflation that clears the market. Targeting such a measure of inflation does not make sense from the point of view of allocative efficiency. The underlying inflation is somewhere between WPI inflation and CPI inflation in a predominantly market economy like India. The wider divergence between WPI and CPI inflation is often cited as the excuse to abandon targeting headline CPI inflation. Divergence between WPI and CPI inflation is nothing new as both the indices are based on different weighting diagram.
Market imperfection is a structural problem in India. Despite a record level of agricultural output consecutively for several years, Indian consumers have been paying through their nose for the essential commodities, particularly for food items due to the existence of exploitative value chains. The government is committed to reducing imperfections in the agricultural value chain through structural reforms.
The CPI inflation even in an exceptional year like FY21 would have been around 6% had there been a change in the base year from 2012 to 2018. This could not be done as the government had to abandon the report of the Consumer Expenditure Survey of 2017-18 due to poor data quality.
When India’s per-capita income has been rising, the proportion of income spent on food items ought to decline, similar to many other countries in the world. Hence, the relative weight of food and beverage in India’s CPI basket would have been much less than the existing one had there been a timely change in the base year. In case of CPI-IW whose base year has been recently changed to 2016, the weight of food and beverage has declined from 46.2% to 39.2%. The CPI-IW inflation in November 2020 was 5.27%. As the correlation between CPI inflation and CPI-IW inflation is very high in India, the average CPI inflation with the new base would have been well within the limit of 6% stipulated under the FIT.
The problem lies not with the new framework of monetary policy, but elsewhere in the economy. Going forward, the CPI inflation would move close to the unobserved underlying inflation that clears the market if market imperfections are removed and the base year is reset. Till such time, relatively wider band of +/-2 % around the central inflation target of 4% may be retained as against +/-1% in the case of many inflation targeting countries. In the meantime, the government has to expedite the Consumer Expenditure Survey necessary to change the weighting diagram of the CPI basket.
Any measure of inflation is unlikely to be fully market-clearing unless growth accounting is perfect. In recent years, India’s GDP estimates seem to have an upward bias as a major chunk of the GDP is deflated by WPI, which remained subdued. Similarly, there is a downward bias of India’s GDP estimates as the informal sector is not fully captured in the GDP estimates. Government has to expedite structural reforms in many areas, reduce rural-urban divide, and thereby strengthen competitive forces and improve productivity rather than tinker with the new monetary policy framework.
The accountability is fixed with the RBI if the CPI inflation exceeds 6% on an average basis consecutively for three quarters. The inflation target of 4+/-2% should also be on an average basis rather than on a point-to-point basis. The remaining provisions under the FIT should ideally be left unchanged for the next 5 years. While setting the Repo rate, Members of the Monetary Policy Committee are capable of exercising their option judiciously keeping in view the growth objective in all circumstances under the exiting FIT.
*The author is former Principal Adviser and Head of the Monetary Policy Department, RBI. Views are personal.