<b>Charan Singh:</b> Inflation targeting - What's the hurry?

Using a western-assembled model in haste could prove economically and socially counterproductive for India

Inflation targeting could be the next major policy measure adopted in India as the proposal is being reviewed by the Reserve Bank of India (RBI). The finance minister in a recent meeting of the RBI Board is reported to have observed that inflation targeting should be fixed by the central government. Earlier, in late January 2014, the Expert Committee to Revise and Strengthen the Monetary Policy Framework (RSMPF) had submitted the report recommending inflation targeting.

The RSMPF committee proposes that the inflation targeting approach be adopted by January 2016, with headline consumer price index as a nominal anchor. But two issues flagged by the RSMPF committee need attention - composition of the monetary policy committee and debt management by RBI, even if supply side factors, which can be summed up as the "onionisation of price indices", are ignored.

But first, it is surprising that nationally important macro policy issues such as inflation targeting are being addressed either by committees set up for different objectives or in hurriedly prepared reports. To illustrate, the Mistry Committee Report (2007), aiming to make Mumbai a financial hub; the Rajan Committee (2009) on financial sector reforms appointed by the Planning Commission and not RBI; and the RSMPF committee, mandated to complete the report in three months.

Changes in monetary policy framework deserve focussed attention and a well chalked-out strategy to be successful. Illustratively, the foreign trained but domestically experienced duo of Montek Singh Ahluwalia and and C Rangarajan ensured that the reforms of 1990s were properly sequenced, well calibrated and widely consultative in nature. Only then did that well-thought-through policy approach led India to the higher stratosphere of steady economic performance.

To enhance accountability of monetary policy decisions, the RSMPF committee recommends a full-fledged monetary policy committee (MPC). This is in consonance with international practice. But the devil is in the details since three of the five-member MPC would be from the RBI. In general, the MPC is not only expected to be accountable for monetary policy decisions but also bring to the discussion thinking and expertise on various aspects of the diverse economy. An advanced country such as the non-inflation targeting US has 12 members, while the UK has nine. India, a vast, developing country with weak financial markets and large inequalities of income and industrial development, does not have an effective transmission mechanism for monetary policy. In the absence of the "Beige Book" containing regional developments on a near real-time basis, a larger number of MPC members with diverse domain expertise would be a truly representative group and lend credibility in monetary policy decisions.

The other aspect is management of internal debt, in which RBI's important role could conflict with its pursuit of the objectives of monetary policy. The RBI's monetary policy partly aims to provide adequate liquidity and maintain an appropriate interest-rate environment. In India, in recent years, interest rates of gilt-edged government securities have been substantially lower, and generally steady despite market turbulence, than the average lending rate of commercial banks. This could be interpreted to imply that RBI makes efforts to ensure that the government borrows at lower rates of interest, which can be substantiated by the fact that there is convergence in yields of the government securities and open market operations (OMOs) auctions.

The RSMPF committee acknowledges that OMOs have largely become one-sided in recent years and resulted in expanding reserve money and indirectly monetising the fiscal deficit. Hence the RSMPF's recommendation that OMOs should be delinked from fiscal operations and "should not be used for managing yields on government securities". This observation is, indeed, a grim reminder of the era of ad hoc Treasury Bills, which reigned supreme from 1974 to 1993, camouflaging the actual implications of fiscal deficits. Generally, the separation of debt from monetary management enhances credibility and independence necessary to pursue an inflation target, which is still uncertain in India.

Finally, globally, until 2008, some countries, a few at the push of the International Monetary Fund, had been switching to an inflation targeting regime after the successful adoption by New Zealand (1989), Canada (1990), and the UK (1992). A few emerging market economies also followed, Israel (1997) and South Korea (1998). The great recession stemmed the tide and conversion to inflation targeting by both advanced and emerging markets stopped immediately - inflation targeting helps to stay focussed on one target of inflation, but tends to ignore other variables such as employment, financial stability and growth. A ready illustration is the low growth and rising troubled banking assets in India as a result of the relentless pursuit of controlling inflation through interest rates in recent months. But the hurry to supplant a redundant western-assembled model of inflation targeting may be economically and socially counterproductive, and not appropriate, especially when there is no provision for social security in India. Therefore, India needs a wider debate analysing the reasons for abandoning the time-tested multiple indicator approach successfully used since 1998.

The writer is RBI Chair Professor of Economics, IIM Bangalore.
These views are personal