The first seeds of inflation targeting as a tool of monetary policy have been in vogue since the days of Paul Volcker (FED Chairman) in the 1980s. Persistent double-digit inflation was in the agenda and dysfunctional. High 8- to 10-year interest rates kept US inflation under control.
Although RBI adopted the recommendations of the Urjit Patel Committee on Inflation Targeting in early 2014, RBI tightening had started at least 3 years earlier to rein in inflation resulting from expansionary interventions undertaken to deal with the crisis from 2007-08.
Many commentators have blamed strict inflation targeting for the fall in our growth rates and the persistence of unemployment. Some assumptions in our inflation targeting need to be seriously reconsidered. The choice of the CPI instead of the WPI, the 4% level, the equal band on both sides and the choice of a single 4% are among the most serious. This article is about the latter two.
The central 4 per cent target is meant to be a compromise between protecting the interests of pensioners on the one hand and wage earners and fixed-income debtors, investors and jobs and growth on the other. Investors in physical assets would prefer higher inflation (lower real interest rates), which would facilitate more investment and job creation, but hurt fixed income earners and the working class.
A percentage increase in inflation from 2% to 3% is more bearable for the fixed income category than when it rises from, say, 7% to 8%. On the other hand, the social impact when unemployment rises from, say, 7 to 8%, is much more severe than when it rises from, say, 3 to 4%. The equal band on both sides of 4% needs to be seriously reconsidered. Unfortunately, the 4% +/- 2% assumes this is equal and linear. It’s seriously debatable.
The case of differentiated and multi-level targeting
RBI has chosen to target inflation at a central rate of 4% with a 2% tolerance on both sides. Let’s look at the case of differentiated targeting.
The signaling strength of developing inflationary or deflationary pressures differs from item to item and sector to sector. A 2-3% above normal change in consumer durables, which is discretionary spending, tells us more about people’s confidence in job stability, maintenance of their income levels, capacity utilization and demand pressure. A similar variation in food and beverages (46% in the combined basket and 54% in the rural basket) may well occur on a day-to-day basis in many markets. Similarly, housing prices and rents in urban areas, which represent a large percentage, have a stronger message than fuel or gasoline.
A 5% change (say from 2% to 7%) in food inflation would result in a 2% rise in inflation, pushing it beyond the central target range, while a 10% increase in furniture, appliances and utensils that all show obvious signs of overheating may trigger no action, as they would increase inflation by less than 0.5%.
Second, inflation of 8% in food and 2% in all others would lead to well-controlled inflation of 5%. But persistent inflation of 8% can push many people in rural areas, where more than 50% are net food buyers, into distress and below the poverty line. The distress of a person with a higher weight in his consumption basket compared to the average is all the greater when his inflation is higher than the average. Of course, that’s the curse of all averages. But its impact on the lower strata on the edge of poverty is much greater than when one is well above the average. This can be partially offset by lower limits for food inflation, especially sub-items consumed by vulnerable sections.
Third, the reliance on formal credit and the transmission (both percentage and speed) of control measures on different items and sectors varies considerably.
Fourth, inflation in certain sectors like construction, transport, health, housing rents trickles down to factor markets (like wages) and gets very sticky, while inflation in items like Food and fuel doesn’t stay sticky for as long and often doesn’t affect factor markets. only strongly in the short term.
Export-oriented sectors will be hit by domestic monetary action as prices abroad barely move in tandem, affecting their operations. Existing concessional export financing schemes largely cover credit for the final stage, but changes in all previous stages which may be of the order of 3/4 do not impact them.
A single inflation target may be more acceptable when inequality is low or when people’s minimum income covers most essentials, so the risk of falling back into poverty or distress is low. But in low-income societies with high inequality, it can seem unforgiving. Average levels of inflation may be acceptable for financial markets that can move from one instrument to another or from one market to another at the click of a mouse, but inappropriate for the real economy with habits of more rigid consumption.
It would be more useful to have less than 3-4% for consumer durables and discretionary items before pressing controls. Under food, staples that the poor depend on can be targeted to an upper limit of 4% to initiate action, including an agreement with the government on PSM. For fuel and lighting, it can be 8% given its non-adherence. Exporters should be compensated for interest increases at an earlier stage.
At a minimum, it would be good to observe the targets and range for each category level in the CPI individually so that undue pressure does not build up without adequate action wasting vital time.
The writer is the author of Making Growth Happen in India (wise)