Inflation targeting: Deconstructing the two views about it

Acceptance of a limited macroeconomic role of the Reserve Bank of India would legitimise greater government intervention in the economy, making neo-liberal economists unhappy. This is the central reason for not giving up inflation targeting or modifying it to suit Indian conditions, writes Prof. Arun Kumar.

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GROWTH acceleration is a current concern. Last week, speaking at the 114th annual general meeting of the Southern Indian Chamber of Commerce and Industry (SICCI), the Union finance minister Nirmala Sitharaman exhorted India Inc. to take advantage of schemes to 'leap forward'.

On the same day, speaking at FIBAC 2024, the Reserve Bank of India (RBI) governor Shaktikanta Das urged the private sector to invest in a significant manner.

In its 2024 report, the International Labour Organisation (ILO) has said that globally the share of wages has been declining, leading to greater inequality. In India, with unemployment high, workers' purchasing power is restricted, leading to a demand problem and slowdown.

Real Gross Domestic Product (GDP) growth for Quarter 1 2024–25 has come at 6.7 percent compared to the previous year's 8.2 percent. It is a five-quarter low. This increases India's challenge to become the third-largest world economy by 2027. Uncertainty due to the general elections and extreme weather events which impacted agriculture and consumption could be the reasons behind the slowdown.

For the private sector, high interest rates could be a factor for investment not picking up, in spite of the incentives given by the government. The Economic Survey of the Union ministry of finance argued in favour of the RBI reducing interest rates. But the RBI has not obliged in its August 2024 Monetary Policy Committee meeting.

So, perceptions of inflation and its control differ between RBI and the Union ministry of finance. These reflect the differing macroeconomic views of the Indian economy. Both institutions have a role in control of inflation even though the RBI is given the primary role.

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RBI's policy primarily targets inflation but also keeps an eye on GDP growth. But in a developing economy such as India both these are problematic.

Inflation targeting

The RBI is required to keep inflation in the range of 4 percent + 2 percent. For this, it primarily adjusts interest rates and the availability of liquidity in the economy. This is called 'inflation targeting'— an idea borrowed from advanced countries. Inflation targets differ across countries but the framework remains the same.

However, neither in India nor in the advanced countries has inflation targeting achieved its goal for some time. In spite of high interest rates, post-pandemic, inflation rates remained at elevated levels in India and abroad.

Pandemic was a shock to the global economy and hit production. Its effects tapered off slowly so supply bottlenecks persisted in the global economy resulting in inflation.

Since different countries dealt with the pandemic in different ways, supply bottlenecks persisted. For instance, China, the global manufacturing hub, relaxed lockdown late while the US had a lax lockdown.

So, supply chains remained disturbed for long and output took time to recover. Additionally, labour markets were disturbed, there was excess money supply due to loose money policies adopted by Central banks, shipping rates remained high, pricing power of the corporates increased as the small-scale sector recovered slowly and so on.

As the pandemic abated, shocks were administered by the war in Ukraine in February 2022 and the Israel–Palestine war starting in October 2023. Again, supplies got disrupted with severe impact on food, fertilisers and energy. The food situation has also been impacted by extreme weather phenomena. In India, production of cereals, vegetables, pulses, etc. has been impacted.

The Central bank interest rate and liquidity policies to control inflation work by reducing demand. They cannot relieve supply constraints due to pandemic, war and weather. That is why Central Bank policies have had little impact on inflation for some time.

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Given this situation, some analysts have been suggesting that RBI's inflation targeting should leave out food and fuel prices. Inflation, leaving out food and energy prices, is called 'core inflation'. Now, the Economic Survey 2024 suggests, "it is worth exploring whether India's inflation targeting framework should target the inflation rate excluding food".

The RBI has disagreed with this view for two reasons. First, the poor are impacted by food prices and they would be short-charged by such a change. Second, food prices feed wages and then impact general prices. So, interest rates should not be lowered, lest increased demand feed into core inflation.

False controversy

The first argument is incorrect. The suggestion that 'core inflation' rather than 'headline inflation' be targeted does not mean that inflation will be differently measured.

The Consumer Price Index for industrial workers or agricultural workers would not change since the consumption basket is not being altered. So, the full impact of food price changes would be accounted for and the dearness allowance of the organised sector would be based on that. The unorganised sector anyway does not get a dearness allowance and would continue to suffer.

The only change would be that the RBI would use a different yardstick to frame its monetary policy. Would the second point be valid and would inflation accelerate rather than getting moderated? That would not be so since the economy is currently facing a demand shortage.

RBI's capacity utilisation data shows that it has hovered between 72–76 percent. This is for the organised sector and would be even less if the declining unorganised sector could be taken into account.

In fact, interest rate reduction could spur investment, all else remaining the same, and lead to higher growth without impacting prices. If this leads to a revival of the unorganised sector, even employment generation would receive a boost— a crying need of the Indian youth.

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Will food price increase feed into general prices over time as wages adjust? Given that the RBI is unable to impact food prices, that would happen irrespective of what is targeted.

But that is unlikely since wages lag behind price increase. The reason is that organised sector workers do not have full indexation while the vast unorganised sector has no indexation. RBI's monetary policy has little impact on this wage–price dynamics. Inflation largely benefits businesses as their margins increase.

In brief, the RBI policy cannot alleviate the supply constraints that lead to food and energy price increase, but its policy can spur investment and spur growth of the economy without causing core prices to increase, given the demand shortage. Then, why is the RBI reluctant to move to 'core inflation' targeting?

Why the reluctance?

Perhaps, the RBI does not want to admit that it has a limited role in controlling inflation. Even in the advanced economies, Central Banks have not been able to control inflation over long periods of time.

This is said to be due to the lags in the system and slowness of the transmission mechanism, etc. When advanced economies with better structural features and more robust data face difficulty using monetary instruments to control inflation, the task in a developing economy such as India becomes far more difficult.

India has a vast unorganised sector, employing 94 percent of the labour force, which is largely out of the remit of monetary policy instruments. The inflation faced by this sector has a high component of food price increase which RBI's policy is not able to impact.

Similarly, the energy price increase is determined by external factors, not in the control of the RBI policy. Thus, the two big causes of inflation, especially for the unorganised sector, are not in RBI's control. Further, the unorganised sector's official growth data is flawed since it is mostly proxied by the organised sector. This was perhaps alright prior to demonetisation but not since then due to the structural breaks and shocks to the economy.

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In brief, the RBI has a limited role in its primary task of checking inflation faced by the vast majority of the citizens and in its secondary task of supporting growth. Its macroeconomic role is largely confined to managing money supply, foreign exchange, government debt, regulation of banking and the world of finance.

It is also argued that RBI helps anchor expectations. But expectations have been belied repeatedly and this adversely impacts decision-making by economic agents— and that is a bigger danger.

A reason for the RBI not reducing interest rates is to maintain the differential with the US rates. If this differential narrows, there is risk of flight of capital leading to depreciation of the rupee and increased inflation.

A consequence of acceptance of a limited macroeconomic role of the RBI would be that it would weaken the argument for RBI's autonomy. Fiscal policies would become more important and that would legitimise greater government intervention in the economy.

Neo-liberal economists of various hues would be unhappy with such a proposition. This is the central reason for not giving up inflation targeting or modifying it to suit Indian conditions.