Inflationisntanislandwhichiseasytotarget

October4,2016,12:21AMISTEconomicTimesinETCommentary| Economy,India|ET

ByJaideepMishra
Thereseemstobepathbreakinginnovationinthedomainofpolicymaking,withexplicitinflationtargeting
verymuchontheagenda.Also,thereistheMonetaryPolicyCommitteeinplacetodeliberateanddecideon
thepolicyrateoftheReserveBankofIndia(RBI).Thewayaheadistohaveflexibilityanddiscretioninbuilt
inthenewapproach,soasnottobeboundbyrigidpolicyruleslinkedtotheconsumerpriceinflation(CPI)
rate.Thepolicyobjectiveofinflationtargetingistosteertheactualinflationratetowardsthetargetrate.
And,inIndia,suchastancecanimposetotallyavoidablecostsintermsoflostoutputandemployment.
Itistruethatinrecentyears,inmostmaturemarkets,thereisasystemofinflationtargetinginvarious
formsforamorepredictableandrulebasedmonetarypolicyregime.Alowtomoderateinflationrateand
theconsequentpricestabilityareknowntoincentiviseinvestment,thecoagulationoffundsandrelated
decisions.

Countingontheseblokes

However,tointerpretinflationtargetingasapolicyruleandoperationalinstructiontothemonetaryauthority
wouldbequiteincorrectandinaccurate.Forinstance,inNewZealand,wherethepracticeofinflation
targetingbeganasearlyas1990,thereisexplicitprovisionforpolicyflexibility.
Thetargetinflationratethereexcludesmovementsincommodityprices.Eveninthemostexplicitlyinflation
targetingregimes,thereisampleprovisiontorespondtosupplyshocksorothertraderelateddevelopments,

sothatthepolicyrateofthecentralbank,whichdeterminesthecostoffundseconomywide,isrealistic.The
ideaisnottodistortthepolicyduetovolatilityinfuelandfoodprices.InIndia,weneedtobeextracautious
inmechanicallydecidingthepolicyrateoftheRBI,goingbythelatestestimatedCPIfigure.
Also,unlikeinthematuremarkets,itisparforthecoursehereforpricesofspecificfooditemstoseasonally
riseinpartduetoincompletemarkets,andtheabsenceofcoldchains,properlogistics,etc.Insucha
scenario,linkingCPItotheoperationalreporateoftheRBIwouldbehugelydistortingandsuboptimal.
ItfollowsthatinflationtargetingintheIndiancontextcanmeanthoroughlyquestionableandhighrelative
costoffundsrightacrosstheboard.Andtheexplanationforatightmonetarypolicyanddearercostoffunds
thatinterestratesbeingjustoneparameterintheoverallschemeofthingsis,atbest,weak.Foroperational
purposes,artificiallyhighinterestratesusuallyleadtoadisproportionatesqueezeonmargins.
Besides,policymakersneedtotakeintoaccountthecontinuinglacklustretrendinoutput,employmentand
creditgrowthtoreducethecostoffundsandthepolicyrategoingforward.Hence,theheightenedneedfor
increasedcommunicationofthemonetaryauthoritywiththepublicandthevariousstakeholders,aboutthe
plans,targetsandobjectivesofthemonetarypolicymakers.Itisvitaltodosoinordertoanchorinflationary
expectationsandstempricerise.
Alongwiththis,theRBIandthegovernmentneedtoputinplaceaproactivepolicyformorecomplete
marketsacrosssectorsandindustries.Itwouldprecludepricespikesinspecificfooditems,andbringabout
bettertransmissionofmonetarypolicytotheeverydayrealeconomy.Thefactofthematteristhattotransmit
monetarypolicysignalsviainterestratesandtheeffectivecostoffunds,weneedtostrengthenanddevelop
thefinancialsector.Advancedeconomieshavewelldevelopedandsophisticatedfinancialsystems
characterisedbythriving,liquidmarketsinbonds,currenciesandcommodities,andcorrespondingderivative
instruments.Thefinancialproductsarenecessarynotjusttomanagerisksandvolatilitybutalsotoquite
seamlesslytransmitmonetarysignalstothelargereconomy.
Butthetransmissionmechanismisweakhere,givenahostofrigidities,includingthehighratioofnon
performingassets(NPAs)inthebankingsystem,nottomentionbecausethebond,currencyandcommodity
marketsremainsubstantiallyunreformed.Suchastateofaffairswouldhampermonetarypolicytransmission
anddefeattheverypurposeofinflationtargeting.Itisnotablethatoflate,theRBIhasbeenthinkingaloud
aboutshoringupthecorporatebondmarketbyraisingthedemandandsupplyofbondsandimproving
marketmaking.
Thereisalsotalkofallowingoptionsandnotmerelyfuturescontractsforakeyassetclasslike
commodities.Movesarealsoreportedlyunderwaytoallowbanks,mutualfundsandinsurancecompaniesto
investincommodityderivatives.Yet,rigidinflationtargetinginascenarioofincompletemarketssurely
makeslittlesense.