18th March 2021 – Editorials/Opinions Analyses

Contents

1. Re-evaluating inflation targeting

Editorial: RE-EVALUATING INFLATION TARGETING

Context:

As the term of the original agreement between the Centre and the Reserve Bank of India (RBI) on inflation targeting ends on March 31, evaluations of this aspect of monetary policy have begun to emerge in the public domain.

Relevance:

GS-III: Indian Economy (Economic growth and development, Macroeconomics – Inflation, Business cycle)

Mains Questions:

1. Inflation control will always be relevant but there is no conclusive evidence that the policy has worked in India. Discuss. (10 Marks)

Dimensions of the Article:

1. What is inflation?
2. When is High Inflation a Problem for the Economy?
3. When is Inflation Good for the Economy?
4. What is Inflation Targeting?
5. How is Inflation Controlled?
6. Advantages of Inflation Targeting
7. Disadvantages of Inflation Targeting
8. Logical vulnerabilities
9. Conflicting patterns
10. Way Forward

What is inflation?

• Inflation is defined as an increase in general level of prices which is sustained over a period of time.
• It is inflation only if prices of most goods have gone up.
• Consequently, the purchasing power of the currency falls.
• One of the ways to measure inflation is to estimate how much the Consumer Price Index (CPI) {CPI tracks the change in retail prices of goods and services which households purchase for their daily consumption} has increased in terms of percentage change over the same period the previous year.

When is High Inflation a Problem for the Economy?

Income redistribution

• One risk of higher inflation is that it has a regressive effect on lower-income families and older vulnerable citizens who might be living on a fixed income.
• If prices are rising faster than wages, then there will be a steep decline in real incomes.
• Inflation tends to redistribute income and wealth towards groups who are better able to hedge against inflation by sheltering their assets in ways that earn a decent return.

Functions of money

• Hyperinflation destroys the internal purchasing power of money and undermines its value as a medium of exchange and as a unit of account.
• Alternative currencies that at least hold some of their value may take the place of the domestic unit of exchange and shadow markets with products traded at unofficial prices often become the norm.

Increased cost of borrowing

• High inflation may also lead to higher borrowing costs for businesses and people needing loans and mortgages as financial markets seek to protect themselves against rising prices and increase the cost of borrowing on short and longer-term debt.

Government spending

• High inflation puts pressure on a government to increase the value of the state pension and unemployment benefits and other welfare payments as the cost of living climbs higher.

Inflation expectations and wage demands

• High inflation can lead to an increase in pay claims as people look to protect their real incomes.
• This can lead to a rise in unit labour costs and lower profits for businesses. However, not all workers belong to strong trade unions who can use collective bargaining power to bid for higher pay.
• A rise in actual inflation can lead to an upward shift in inflation expectations (which can be modelled using Phillips Curve analysis) and once inflation is embedded into an economy, it can be difficult to eliminate.

Negative real interest rates

• If interest rates on savings accounts in banks are lower than the rate of inflation, then people who rely on interest from their savings will be poorer.
• Hyperinflation destroys the value of savings and means that many families are exposed to high interest-rate debt.

Business competitiveness in domestic and international markets

• If one country has a much higher rate of inflation than others for a considerable period of time, this will make exports of goods and services less price competitive in global markets.
• Eventually this may show through in reduced export orders, lower operating profits and fewer jobs, and also in a worsening of a country’s trade balance.
• A fall in exports can trigger negative multiplier and accelerator effects on real national income and employment.

When is Inflation Good for the Economy?

Boosting Consumer demand and Economic Growth

• Inflation is viewed in a positive manner when it helps boost consumer demand and consumption, driving economic growth.
• Example for inflation boosting demand and consumption: If the price of cars were to be dropping consistently (deflation) then instead of buying a new car in the present year, the consumers will prefer to buy it in the coming years when the car is cheaper. A little inflation would act as an encouragement to buy it in the present itself rather than wait and buy it at a higher price.
• This increased demand boosts economic growth.

Effect on wages

• Steadily Rising prices make it easier for companies to put up wages.
• They also give employers the flexibility not to increase wages by as much as inflation, but still offer their staff some sort of rise.
• In a world of zero inflation some companies might be forced to cut wages, and this would not be good for morale, recruitment or productivity.

What is Inflation Targeting?

• Inflation targeting is a monetary policy strategy used by central banks for maintaining inflation at a certain level or within a specific range.
• In general, central banks normally follow a policy of keeping inflation sufficiently low.

In the recent past, several countries have been opting for inflation targeting as a monetary policy objective due to following reasons:

1. It has strong correlation with market demand.
2. The idea is predictable and easy to understand for private sector and residents.
3. Inflation Targeting mechanisms generally increase transparency.
4. Stabilizing impact on other economic parameters like exchange rate volatility etc.

How is Inflation Targeting done?

• Inflation targeting is done by raising or lowering interest rates based on above-target or below-target inflation, respectively.
• The conventional wisdom is that raising interest rates usually cools the economy to rein in inflation; lowering interest rates usually accelerates the economy, thereby boosting inflation.

How is Inflation Controlled?

There are broadly two ways of controlling inflation in an economy:

1. Monetary measures and
2. Fiscal measures

Monetary Measures

• The most important and commonly used method to control inflation is monetary policy of the Central Bank (RBI in India).
• Most central banks use high interest rates as the traditional way to fight or prevent inflation.

Monetary measures used to control inflation include:

1. Bank Rate Policy
2. Cash Reserve Ratio and
3. Open Market Operations.

Fiscal Measures

• Fiscal measures to control inflation include taxation, government expenditure and public borrowings.
• The government can also take some protectionist measures (such as banning the export of essential items such as pulses, cereals and oils to support the domestic consumption, encourage imports by lowering duties on import items etc.).

Advantages of Inflation Targeting

• Inflation targeting allows monetary policy to “focus on domestic considerations and to respond to shocks to the domestic economy”, which is not possible under a fixed-exchange-rate system.
• Transparency is another key benefit of inflation targeting. Central banks in developed countries that have successfully implemented inflation targeting tend to “maintain regular channels of communication with the public”.
• An explicit numerical inflation target increases a central bank’s accountability, and thus it is less likely that the central bank falls prey to the time-inconsistency trap. This accountability is especially significant because even countries with weak institutions can build public support for an independent central bank.

Disadvantages of Inflation Targeting

• There is a propensity of inflation targeting to neglect output shocks by focusing solely on the price level.
• Leading economists argue that inflation targeting would maintain or enhance the transparency associated with a system based on stated targets, while restoring the balance missing from a monetary policy based solely on the goal of price stability, thus neglecting other factors of an economy as well.

Logical vulnerabilities

• The economic model that underlies inflation targeting has remained in hidden in public discourse.
• This model revolves around the proposition that inflation reflects “overheating”, or economic activity at a level greater than the “natural” level of output, having been taken there by central banks that have kept interest rates too low, at a level lower than the “natural” rate of interest.
• From this follows the recommendation that the cure to inflation is to raise the rate of interest set by the central bank, the so-called policy rate, which in India is termed ‘repo’ rate. A feature of this theory of inflation is that its central construct, the natural level of output, is unobservable.
• Our work demonstrates that the model that underlies inflation targeting is not statistically validated for Indian data. But instead of going into specifics, we scrutinise in this article whether recent history supports the claim that inflation targeting has been successful on the grounds that the inflation rate has remained within the band agreed to between the government and the RBI, and whether it has been achieved by “anchoring inflation expectations”.

Conflicting patterns

• The economy’s trend rate of growth actually began to decline after 2010-11. So, inflation targeting could not have caused it, but it is of interest that sharply falling inflation could do nothing to revive growth, belying the proposition that low inflation is conducive to growth.
• The swing in the real interest rate of over 5 percentage points in 2013-14 was powered further in 2016, when inflation targeting was adopted, and could have contributed to a declining private investment rate.
• NPAs have grown since 2016 and this suggests that poor management and malfeasance in the financial sector could escape scrutiny when the central bank hunkers down to inflation targeting.

Way Forward

• Coordination between Monetary Policy and Fiscal Policy: Many central banks (e.g., UK) worldwide have the concept of a non-voting representative from the Treasury who attends meetings, expresses the views of the Ministry of Finance, and participates in the discussions. A government non-voting member is a way to coordinate and yet not interfere. This could ensure the much-needed balance between inflation control and economic growth.
• Improving data collection and analysis framework: Reforming the data collection methodologies and framework on lines of draft National Statistical Commission Bill, 2019 can be envisaged.
• In the conduct of monetary policy in an open economy setting, foreign exchange reserves and associated liquidity management are key, there is a need to enhance the RBI’s sterilisation capacity to deal with surges in capital flows.
• The presumed benefits of low inflation are yet to surface. So, we should guard against the possibility that inflation targeting may deliver the worst of all worlds, i.e., raising interest rates, with all negative consequences, without lowering inflation.

-Source: The Hindu