One of the less discussed but important proposals in the Union Budget concerns monetary policy. Finance Minister Arun Jaitley said that it is "essential to have a modern monetary policy framework to meet the challenge of an increasingly complex economy".
What Jaitley referred to are the recommendations of the Urjit Patel Committee, struck by the Reserve Bank of India (RBI), which suggested that India adopt an explicit policy of targeting the new Consumer Price Index (CPI) as its nominal anchor; and, in particular, that it should target four per cent CPI inflation with a tolerance band of plus or minus two per cent around the target.
This would represent a major departure from the current ad hoc arrangement, wherein RBI targets some combination of a number of different nominal variables, such as nominal gross domestic product (GDP), the exchange rate, Wholesale Price Index, and so on, and in which the central bank is not obliged to reveal to the public exactly what it is targeting and why.
While there is much debate on whether CPI targeting is appropriate for an emerging economy such as India, that is for another time. Here, I would like to explain what is meant by "inflation targeting" in the first place, and where this policy - now used by leading central banks around the world - originates.
First, a brief but necessary history lesson. For much of modern history, currencies were tied, directly or indirectly, to precious metals - principally gold and silver. Historically, for instance, the US fixed the price of gold at $35 an ounce - which, in effect, became the US monetary policy. The Federal Reserve, the US central bank, would stand ready to buy and sell gold at $35, and that determined the quantity of dollars in circulation. (Parenthetically, if countries fixed to gold - as most did before the First World War - then the world automatically got a system of fixed exchange rates, since exchange rates would merely represent the ratio of the gold content of any pair of currencies.)
With the collapse of the Bretton Woods system in 1971 - when President Nixon closed the "gold window" - both the "dollar-gold standard" and the system of fixed exchange rates broke down, and central banks had to find a new nominal anchor in the brave new world of "managed flexible exchange rates".
For a time, especially during the 1980s, "monetarism", or, more precisely, "monetary targeting", was in vogue - central banks would simply target the quantity of a monetary aggregate, or the rate of growth of such an aggregate, and the economy would get the inflation rate consistent with that level of monetary growth, given the level of output and the velocity of monetary circulation. This policy is the celebrated "k-per cent rule" of Milton Friedman, who suggested that a central bank should fix the growth rate of the money stock at a chosen rate of "k per cent" as a means to anchor inflationary expectations.
Monetarism came a cropper when central banks discovered that the mapping between the stock of money and the inflation rate was too unstable to be reliable - partly because technological innovations such as electronic banking caused the velocity of money, and so money demand, to fluctuate.
So was born "inflation targeting", in which a central bank would set its monetary policy instrument to ensure that inflation fell within a narrow bandwidth of a preferred target - usually around two per cent in most mature economies.
If current monetary policy determined the current inflation rate, inflation targeting would be trivially easy. However, in reality, because monetary policy affects inflation with a lag of anywhere from six months to a year or more - the so-called "monetary transmission mechanism" - this requires central banks to rely on enormously sophisticated dynamic mathematical models to predict the relationship between current monetary policy and future inflation, so that today's monetary policy can correctly target future inflation.
That is why Robert Mundell argued a long time ago that "inflation targeting" is a misnomer: the policy should, rather, be called "inflation forecast targeting", for that is what is truly involved, and that is why it does not always work as predicted, since forecasts can, and often are, wrong.
Supporters of the policy - and they are legion within the ranks of conventional macroeconomists - argue that inflation targeting, by anchoring expectations of future inflation at (say) two per cent, is better than any other alternative in keeping actual output close to its "potential" or long-run level since the distorting effects of inflation "surprises" are kept to a minimum, and expectations mirror reality.
Critics point to the signal failure of inflation targeting to respond to asset price bubbles - of the sort that preceded the global financial crisis triggered off by the subprime mortgage crisis in the US. By fixating only on CPI inflation, the Fed entirely missed the property market bubble and allowed it to grow and then to blow up. The world is still living with the consequences.
Inflation targeting might be the flavour of the day, but it is not necessarily the holy grail its defenders make it out to be. We ought to be mindful of this in India.
The writer is an economics professor at Carleton University in Ottawa, Canada, and is co-author of Indianomix: Making Sense of Modern India (Random House India, 2012)
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