RBI’s unhealthy obsession with inflation

Based on the Monetary Policy Framework signed between the government and the Reserve Bank of India (RBI) on February 20, 2015, India’s monetary policy moved into an Inflation Targeting (IT) framework. Then on, the RBI’s benchmark repo rate has been decided with the sole objective of keeping inflation within a band of 2-6 per cent, based on the Consumer Price Index (CPI). A six-member Monetary Policy Committee (MPC) with the RBI Governor as the Chairman was set up by amending the Reserve Bank of India Act, 1934, to decide on the benchmark rates.

This move towards an IT framework has been widely hailed as a step towards a more prudential monetary policy in India. The reasons are very clear. First, this new framework provides full flexibility to the RBI to use all the tools at its disposal to ensure that inflation stays within reasonable bounds. Second, by making the RBI responsible only for keeping inflation in check, the government is forced into fiscal discipline as the Central Bank is no longer willing or able to monetise the government deficit. As a result, monetary and fiscal policies are undertaken by two different branches of the state, and effectively independent of each other. Given these apparent advantages, it is not surprising that most of the developed countries have moved towards an IT framework starting with New Zealand in 1988. This has resulted in these economies experiencing low but stable inflation with government spending under check. On the other hand, most of the developing countries continue to influence their central banks into monetising the government deficits, thereby resulting in high inflation with unpredictable monetary policies.

Yet, in recent years, IT has come under scrutiny. It has been felt that IT may not be suitable for developing countries like India for two important reasons. First, monetary policy mostly affects aggregate demand while prices in developing countries are mainly determined by supply-side factors like oil imports and agricultural production (which is dependent on rainfall). Second, while low inflation is important for businesses, what matters more for the economy is growth. Sometimes, there can be a conflict between the two as we see in India. The MPC, anticipating rising inflation due to increasing oil prices or food shortages, might raise interest rates which has a dampening effect on investments by firms which negatively affects our growth rates.

Some economists, therefore, advocate moving away from the Inflation Targeting framework of the RBI and towards a Nominal GDP Growth Targeting framework. Nominal GDP growth is the sum of real GDP growth and inflation.

In developing countries, a supply shock (say, rising oil prices or drought) increases input costs and raises prices and inflation rates. At the same time, it lowers the rate of growth of real GDP. So, the net effect on nominal GDP growth depends on the magnitude of inflation and real GDP growth. It is possible that the two cancel each other out. In the present IT framework, RBI would raise interest rates to lower inflation. But this would worsen real GDP growth even further. In the Nominal GDP framework, the RBI need not do anything. This would prevent real GDP growth from worsening further.

The author is a research scholar at Delhi School of Economics