Is inflation targeting dead?

With the Reserve Bank of India policy review just around the corner, it is time to take a hard look at the efficacy of monetary policy or inflation targeting since the financial crisis of 2008. It has been more than 25 years since inflation targeting arrived on the scene and since then it has grown to dominate central bank strategies across the world. It is currently facing its most stubborn test on efficacy. This reminds me of the North American opossum. When threatened, opossums, act as if they are dead. My question is, whether inflation targeting as a policy tool is exhibiting similar characteristics or is it actually dead. It is important that we analyse the recent history of monetary policy making across economies to understand that better. 

First, despite quantitative easing (QE), developed countries have not been able to keep inflation at their target level. Inflation increased between 2009 and 2011, but it could not remain elevated. It seems central banks are not being able to increase inflation by QE (though recent readings suggest an inflation rate closer to 2 per cent, the first occurrence since early 2012). Remember, the US has had a massive $3.5 trillion QE since the crisis, but it could do little to uplift inflation on a sustained basis over the Fed’s 2 per cent target. In short, with the exception of the Bank of England (though an outlier as it is adjusting with Brexit), central banks in major markets have struggled to meet their inflation mandates despite several years of low interest rates and massive QE programmes.

This brings us to the issue of efficacy of inflation targeting by central banks across the world, with particular relevance to India. There are primarily two reasons why there has been a decade of disinflation across the world. 

First, the argument of Broken Philips curve. Unemployment rates have hit new lows in a number of countries. Age-adjusted labour force participation is rising and the number of job openings in the US now perhaps exceeds the number of jobless persons. However, wage gains are still limited and much lower than during past cycles. There are a range of potential explanations for this apparent disconnect. Automation (present and future) is being effectively used by firms to limit compensation costs. Workers seem to have far less leverage than they used to, as union membership declines and structural labour force reform advances. Most importantly, labour productivity in many markets has been growing slowly, thus limiting the gain in real wages. 

The more compelling reason however, is that the headline US unemployment rate captures only those who are actively looking for work. A better measure of labour market tightness appears to be the employment-to-population ratio of prime age workers, aged 25 to 54 years. The US prime-age employment to population ratio is 79.2 per cent, down from 80 per cent in early 2007. As per estimates, this drop effectively suggests that around 1 million additional prime-age Americans would be available to work if the US labour market recovered to its pre-recession strength, thereby pushing up wage growth.

The growth in the labour force which is preventing real wage from rising is also responsible for current low inflation in India. The lower increase in wages has resulted in less spending by consumers, leading to weak inflation dynamics. For India, the wage bill of listed companies currently shows a distinct slowdown based on audited annual reports in FY18, down from 13.4 per cent in FY16. 

Second, e-commerce has made consumers more decisive, offering a better way to compare products and services. As a result, inflation for goods lags well below inflation for services in almost every developed market. The important thing to note is, services are being disrupted by new providers and on new platforms, suggesting that their prices, too, will come under downward pressure. This seems more like a steady paradigm shift than a sudden level change, so policy makers will have to build this into their inflation forecasts, their inflation targets, or both.

Interestingly, in the Indian context, the gap between service and goods inflation as constructed from CPI is currently showing a clear convergence, even as service prices are rising. 

Interestingly, the success of inflation targeting is sometimes over emphasised. Between 2002 and 2008, inflation declined in most countries and this was mainly attributed to the increase in IT-engineered productivity. The productivity rebound in the global economy till 2008 was widespread, with approximately two-fifths of the productivity rebound occurring in new economy industries (computers, semiconductors, software, and tele-communications). Overall, such higher productivity led to lower prices, expanding demand, leading to higher employment.

Notwithstanding the criticism against inflation targeting, a predictable inflation environment does provide a favourable foundation for economic growth and employment. It facilitates business planning, keeps long-term interest rates well-anchored, mostly appreciating currency and supports long-term investing.

So where we go from here?

One way to make inflation targeting successful in India is to reach the 4 per cent target over a particular business cycle rather than for a particular date. Remarkably, inflation in India has been running exactly at 4 per cent for the last two years. Monetary policy could have aimed for, say, 4.5 per cent for two years. This would encourage a predictable inflation targeting in the face of persistent negative shocks. Such history dependent policy has been effectively implemented by the Reserve Bank of Australia, with 2-3 per cent target on an average over the business cycle. The economic performance of that country has been excellent. Average inflation in Australia since 1995 is 2.7 per cent, close to the 2.5 per cent mid-point with no record of recession in 25 years!

Before we close, we expect the August 1 policy to take a wait and watch stance as global uncertainty continues to unfold. Successive rate hikes in such an uncertain environment may be counterproductive. 

The author is group chief economic advisor, State Bank of India. Views are personal