Can India afford it?

flexible inflation targeting: In the realm of policy making, the idea is gaining strength as aficionados feel, it aims to predict and arrest rate of i

Is India ready for flexible inflation targeting? No definite answer, but efforts are on to make it happen. The signing of agreement in February this year between the Finance ministry and the RBI is a step in that direction.

In the realm of policy making, the idea is gaining strength as aficionados feel, it aims to predict and arrest rate of inflation. Inflation being a serious impediment in the economic prospects of a nation, a timely check can yield large dividends.

Currently the government and central bank are getting worked up to go for such a kill. Their possible explanation lies in the fact that when crude oil prices are low, rupee-dollar ratio within manageable limit, growing per capita income among Indians is rising, there is assured political stability and inflation under control, institutionalisation of such policy will positively help the economy to reach its potential level.

Such thinking is expected, but only doable provided one manages to keep the rate of inflation within its limit of 2 to 6 per cent. However, one of the biggest macroeconomic challenges of Indian economy has always been how to accurately measure the rate of inflation.

Until a year ago, India focused on Wholesale Price Index (WPI) to measure the rate of inflation. Lately, policy makers realised since India is fast emerging as a service-based economy whose contribution to GDP is touching about 58 per cent, data obtained through WPI is not appropriate and realistic as WPI does not include services.

For example, a maid servant working in a house becomes a part of the service industry and it is quite possible that such transactions happening in large numbers in the country are not captured in the database to give us an appropriate rate of inflation. How to get the entire aggregate data of services so easily to make flexible inflation targeting a predictable instrument becomes a challenge.

Looking at this urgency, the government and policy makers have shifted to focusing on Consumer Price index (CPI) as a more inclusive method to determine inflation. The Urjit Patel’s Committee Report (UPCR), the architect behind flexible inflation targeting, favours the use of all India CPI combined inflation against the traditional WPI inflation as inflation metric. Data on CPI is received in a time lag of 1 month compiled by CSO.

The advantage is, it covers gamut of consumers such as industrial workers, agricultural and rural labourers, urban non-manual employees whose consumption data can be taken care of through retail selling.To capture bigger picture, CSO has institutionalised CPI rural and CPI urban.

Secondly, the inflation in India is derived significantly from food inflation. About 57 per cent of inflation is drawn from food sector, associated with agricultural produce such as rice, wheat, fruit and vegetables. Food inflation is rising because it suffers from supply constraint market.

Unpredictability and volatility in the crude oil market and vagaries of monsoon influence production of essential commodities directly as well as the energy market to which developing economies like India has no control. In fact, such supply driven or cost push inflation is less amenable to macroeconomic policy changes particularly beyond the ambit of monetary policy.

Thirdly the inflation targeting may not be practical in case of a developing country like India because the primary concerns of the central bank are to be guided by objectives of sustainable growth, price stability and financial stability. Fourthly, presence of inefficient transmission mechanism occurring due to large fiscal deficits, presence of administered prices and interest rates is contributing to unexpected rise in fiscal instability.

These drawbacks possibly negate the prospects of India becoming ‘flexible inflation targeting’. However there is another side to the story which argues that such policy instrument can prove effective in handling Indian economy to stand in good stead.

Multiple advantages

The advantages are also many. First, it provides a benchmark to the policy planners in terms of registering some-what closer rate of inflation. Predictable inflation with a target of 4 per cent within a band of ± 2 per cent as proposed by UPCR gives a prior idea to frame policies relating to interest rates and exchange rates.

Secondly, one of the most important advantages of having inflation targeting is the accountability and transparency it brings to policy making. It helps in putting a quantitative target, and a fixed target horizon. The central banks following inflation targeting have to publish a regular monetary policy report which includes the bank’s forecast of inflation and other variables. Flexible inflation targeting also helps to monitor other economic variables like output gap; basically the difference between potential output (GDP)and actual output.

Thirdly empirical evidence suggests that an exclusive empirical target for inflation anchors and stabilises inflation expectations. This in turn would stimulate economic growth and would help in larger redistribution of income to reduce poverty especially in a country like India. Flexible inflation targeting has proved resilient during the global financial crisis for some economies.

Lastly, it gives independence to the central bank to target inflation using any instrument it wants to. The new framework makes the RBI more accountable as now it will have to explain to the government if it fails to meet the inflation targets. The targets may restrain RBI from taking any aggressive or accommodating monetary policy stance. This will put India on a par with other nations in terms of flexible inflation targeting.This will make monetary policy more transparent. Coordination between the government and RBI will be strengthened further.

But its success in India will depend on how the food inflation moves. Without food inflation under control, keeping inflation in the band prescribed beyond 2016 will be difficult. One of the countries where inflation targeting has been quite successful in reducing both inflation and output volatility is the UK.

(The writer is Professor, Lal Bahadur Shastri Institute of Management and former Senior Faculty, Indian Institute of Foreign Trade (IIFT), New Delhi)