In 2015, the Reserve Bank, under Governor Raghuram Rajan, adopted 4 per cent consumer price index (CPI) inflation as the anchor for its monetary policy. As governor, I had expressed reservations on inflation targeting. Several people have asked me if I endorse Rajan’s approach. I do, notwithstanding some reservations I continue to have. In order to explain my position, it’s necessary to first understand the issue of inflation-targeting in a broader global context.
Inflation-targeting around the world
The years before the global financial crisis in 2008 saw a powerful intellectual consensus building around inflation-targeting. A growing number of central banks, starting with New Zealand in the late 1990s and thereafter numbering over thirty, embraced the principle of gearing monetary policy almost exclusively towards stabilising inflation. This involved the central bank openly committing to a target for consumer price inflation and making the achievement of that target the overriding priority of monetary policy.
This approach seemed successful, delivering as it did the Great Moderation – an extended period of price stability accompanied by stable growth and low unemployment. In the world that existed before the crisis, central bankers were a triumphant lot. They believed they had discovered the Holy Grail!
That sense of triumph was short-lived. The global financial crisis dented, if not dissolved, the consensus around the minimalist formula of inflation-targeting. Inflation-targeting was premised on the view that if policymakers took care of price stability, financial stability would be automatically assured. The crisis proved that wrong by actually demonstrating the opposite – that an exclusive focus on price stability can blindside central bankers to threats to financial instability.
In light of this received wisdom, central bankers found themselves charged with neglecting financial stability in their single-minded pursuit of an inflation target, and thereby abetting, if not causing, the global financial crisis.
One of the big lessons of the crisis is that financial stability is neither automatic nor inevitable and that it has to be explicitly safeguarded. Central banks, in particular, cannot afford to keep financial stability off their radars.
Does this mean the inflation-targeting approach has to be abandoned altogether? Alternatively, can inflation-targeting be made more flexible to accommodate concerns about financial stability? Quite predictably, these questions were in constant play in international policy conferences as well as in the global media in the post-crisis period. The ensuing debate also raised a host of related questions on inflation-targeting, financial stability and the broader issue of the mandates of central banks.
What exactly is financial stability? Is monetary policy an appropriate instrumentality for preserving financial stability? Is it sufficient? If not, what other policies are required and how should monetary policy dovetail with these other policies? Apart from financial stability, how should the inflation-targeting approach reckon with the imperatives of real-sector variables like growth and employment? Is inflation-targeting possible in a globalised economy where the prices of goods and services are set by global rather than domestic demand–supply balance? How effective is inflation-targeting in economies where wages are determined more by the government’s immigration policy rather than the central bank’s monetary policy? How should the mandates of central banks be redefined to reflect these fresh concerns?
By their very nature, these were open-ended questions, and the only broad consensus that emerged was that inflation-targeting was not the magic bullet it was once thought to be and that strict inflation-targeting should yield to more flexible inflation-targeting, meaning that monetary policy should shift from just stabilising inflation alone to stabilising both inflation around the inflation target and real activity in the economy at its potential level, while simultaneously keeping an eye on financial stability.
Inflation-targeting in India
Coincidentally, in India too, a debate about inflation-targeting started picking up momentum at around the same time, triggered, in part, by two high-profile committee reports, one by Percy Mistry, and the other by Raghuram Rajan. While Mistry strongly urged that the gold standard for stabilising monetary policy is a transparent, independent inflation-targeting central bank, Rajan held that reorienting the Reserve Bank towards inflation- targeting will have to dovetail with the government’s commitment to maintaining fiscal discipline and not hold the central bank accountable for either the level or the volatility of the nominal exchange rate.
The Rajan committee formally presented its report to the prime minister in September 2008, shortly after I assumed office as governor. I was invited to that meeting as were some Cabinet ministers and advisers to the government. I recall that although the committee recommendations straddled a wide range of issues in the financial sector, almost the entire discussion at the meeting was on inflation-targeting.
Opinion was quite varied on whether it was advisable for the Reserve Bank to shift to an inflation target given our macroeconomic circumstances.
In any case, reaching a firm decision on the issue was not on the agenda of the meeting, and we dispersed with the issue of inflation-targeting remaining open-ended. In my first year as governor, even as we were fully preoccupied with the crisis, I had frequently encountered questions on inflation-targeting. Would the Reserve Bank adopt inflation-targeting as suggested by Percy Mistry? Have the preconditions indicated by the Rajan report been met? Is it advisable for the Reserve Bank to move to inflation-targeting at a time when, world over, there is a rethink on its advisability?
My response to inflation-targeting got shaped in this context. I was, in particular, concerned that the Reserve Bank should not move towards inflation-targeting when the theory and practice on the subject were in such a flux. Instead, we should wait for the lessons of experience to become clearer and then adapt them to the Indian situation.
My reservations on inflation-targeting extended beyond the lessons of the crisis to India-specific circumstances and vulnerabilities.
In an economy where short-term inflation is driven more by supply shocks, be they of food or energy, than by demand-side pressures, can the Reserve Bank deliver on an inflation target? Will the government support the Reserve Bank by remaining committed to fiscal responsibility or will inflation-targeting become hostage to fiscal dominance?
How effective would inflation-targeting be in a situation where monetary policy transmission is impeded not just by large fiscal deficits but also by administered interest rates on small savings and illiquid bond markets? Wouldn’t the Reserve Bank’s policy of managing large and volatile capital flows compromise inflation-targeting?
My main concern was that inflation-targeting in the face of these compulsions might lock the Reserve Bank into a no-win situation. If it is fixated on fulfilling its inflation target, there may be occasions when the Reserve Bank may have to tighten the interest rate so much that growth and jobs will be hit.
On the other hand, if it fails repeatedly to meet the target, it will risk losing credibility. Once people have lost confidence in an inflation target, it becomes very hard for the central bank to persuade them to trust the target again.
Besides these policy considerations, there was also a very practical issue that prevented a change in the policy regime. A necessary requirement for inflation-targeting is a single inflation index that is representative of the entire economy of 1.3 billion people, fragmented markets, diverse geography and heterogeneous economic conditions. We did not have one.
Notwithstanding my reservations on inflation-targeting, it is not as if I was fully satisfied with the “multiple-indicator, multiple-target approach” that guided monetary policy during my tenure.
Under multiple indicators, the Reserve Bank monitored a host of variables—reserve money, money supply, industrial output, bond yields and equity prices—and juxtaposed that data against output and prices. As for multiple targets, price stability, growth and financial stability were the joint and simultaneous targets of monetary policy, with the inter se priority among them shifting in accordance with the evolving macroeconomic situation.
In theory, this was unexceptionable as it allowed monetary policy to respond flexibly to the changing macro situation. In practice though, the multiple-indicator approach, which allowed the Reserve Bank to shift from one priority to another virtually seamlessly, confused the markets and fumbled our communication. It also diluted the Reserve Bank’s accountability since any policy mix could be explained away as being consistent with the multiple-objective approach.
Internally, we were deeply conscious of the need for our policy calibration to be logical and consistent, but communicating that remained a challenge always, with the result that our policy actions were sometimes criticised in the media and by some analysts as being inconsistent and, occasionally, even arbitrary.
Given this mixed record of the multiple-indicator, multiple- target approach, the shift to an inflation-targeting regime under Governor Rajan’s leadership was, I believe, a well-advised move. In saying so, I am following the example of no less a luminary than Keynes whose famous riposte to a critic when accused of being a flip-flopper was: "When the facts change, I change my mind. What do you do, sir?"
I believe that at least some of the facts underlying my reservations on inflation-targeting have changed.
At a very practical level, we have today a composite all-India consumer price index with long enough historical data points to provide a nominal anchor for the inflation target. Even though the government deviated from the fiscal road map in 2015–16, it reaffirmed its commitment to fiscal responsibility in its budget for the fiscal year 2016–17.
The administered interest rate regime is being dismantled, with the government indexing the interest rates on small savings to the yield on government securities. That should ease the impediments to monetary policy transmission and support inflation-targeting. The food distribution network is improving, thereby reducing the chance of food supply shocks undermining the achievement of the inflation target. With the softening of oil prices, the probability of supply shocks from oil has also become low.
Also, contrary to my initial apprehension, the Reserve Bank’s inflation-targeting framework builds in significant flexibility. Importantly, the monetary policy framework agreement between the government and the Reserve Bank acknowledges that the objective of the monetary policy is to maintain price stability “while keeping in mind the objectives of growth”, thus discouraging the Reserve Bank from adopting a rigid approach to achieving the inflation target. The statement on the Reserve Bank’s website “that the relative emphasis assigned to price stability and growth objectives in the conduct of monetary policy varies from time to time depending on the evolving macroeconomic environment” reiterates the flexible inflation-targeting approach. Moreover, the wide tolerance band of ±2 per cent around the inflation target of 4 per cent reinforces this flexibility.
In the event of failure to meet the inflation target, the framework agreement enjoins the governor to report to the government the reasons for failure, as also the remedial action being taken to return inflation to the target range. This provision is comforting as it acknowledges the possibility that the target could be missed under extenuating circumstances, thus minimising the probability of the Reserve Bank pursing the inflation target “at any cost”.
Going forward, the success of the Reserve Bank’s inflation- targeting approach will depend on two factors: first, how intelligently the flexibility of the framework will be used, and second, the autonomy the government will allow the bank in pursuing the target. Let me comment on both of these.
Global experience shows that an inflation-targeting framework is neither necessary nor sufficient to maintain price stability.
Just to cite one example, the US Federal Reserve had adopted, as recently as 2011, a numerical target for its inflation objective but as stated on its website, the Federal Reserve “is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices and moderate long-term interest rates”. Even with this multiple mandate, the Federal Reserve has a better track record on managing inflation expectations, and thus inflation, than economies with an explicit inflation target.
For sure, openly committing to an inflation target helps a central bank guide expectations, and thereby maintain stability in the economy. But that very stability can be impaired by a single-minded pursuit of the inflation target to the exclusion of other macroeconomic concerns. The challenge in inflation-targeting is maintaining credibility even while flexibly deviating from the target when the circumstances so warrant.
The second condition for the long-term success of inflation- targeting is that the government will have to steadfastly respect the autonomy of the Reserve Bank notwithstanding its compulsions to accelerate growth in the short-term. Growth and inflation are not independent variables, which is to say that you cannot simultaneously set targets for growth and inflation. If one is fixed, the other is automatically determined.
In practical terms, this means that if the Reserve Bank is enjoined to deliver an inflation rate, the government will have to acquiesce in the growth rate that results. If the government imposes a growth target on top of the inflation target, inflation-targeting will lose credibility. The resultant macroeconomic implications will be costly.
In this context, the following provision in the draft Indian Financial Code (IFC) is perplexing: “The objective of monetary policy is to achieve price stability while striking a balance with the objective of the central government to accelerate growth.”
Is the government implying that accelerating growth is its exclusive objective and the Reserve Bank does not share that objective? Will the government therefore set a growth target and require the Reserve Bank to balance its inflation target with the government’s growth target? Perhaps I am overreacting, but it is important that the wording in the IFC is unambiguous and the intent behind that wording is honoured.
The point to recognise is that monetary policy can only provide a conducive environment for growth to reach its potential; it cannot raise the potential. That remains the government’s responsibility and the task of its supply-side responses.
Needless to say, the Reserve Bank’s inflation-targeting framework is yet to be fully tested. The test will come in a macroeconomic situation when growth is trending down and inflation is trending up, not an unlikely possibility. The test will come if and when commodity prices move back up, pressuring both inflation and fiscal rectitude. The test will also come when the new framework is called upon to address threats to financial stability arising, in particular, from surges and stops of capital.
The Reserve Bank will have to tread the fine line of being flexible on inflation-targeting without compromising its credibility. That will be a difficult – but not an impossible –challenge.
Excerpted with permission from Who Moved My Interest Rate: Leading The Reserve Bank Of India Through Five Turbulent Years, Duvvuri Subbarao, Penguin Viking.
