Originally Published 2014-02-14 07:14:51 Published on Feb 14, 2014
Inflation targeting has become a bone of contention in India. While some economists say a certain level of inflation is a necessary evil, others argue RBI's target is very low and would require monetary tightening. What is required is a balance between fiscal and monetary policy.
Re-thinking India's monetary policy
"In the literature of monetary economics, inflation targeting has an important role to play. It has gained popularity in the recent years and shows the evolution of the monetary policy regimes. However, inflation targeting alone is nothing but an attempt to anchor inflationary expectations and improve confidence in the monetary system. The reliance of India’s policy on this method of combating inflation has come into question given the persistent level of inflation in the country.

An expert committee set up by the Reserve Bank of India (RBI) and headed by its Deputy Governor Urjit Patel recently recommended that inflation should be the anchor point for framing monetary policy and that CPI (consumer price index) inflation should be targeted at 4 percent with a +/- 2 per cent leeway. The debate on whether the primary objective of central banks should be to control prices has come into prominence globally with a slow move away from targeting inflation alone and India should be no exception.

Following the Urjit Patel committee report, analysts have been debating whether to target WPI (wholesale price index) or CPI, but whichever way one looks at it, inflation in India has remained stubbornly higher than the world average from 2008 to 2012. While the world average of inflation in the 2008-12 period was 4.2%, India recorded 10% CPI-IW inflation. If one were to consider WPI instead, the corresponding figure stood at 7.2%, still way higher than the world average, even higher than the average of all developing economies (6.8%). This is despite the fact that India maintains one of the highest interest rates in the world. Hence, inflation is a pressing concern irrespective of how it is measured.

In the wake of the financial crisis, the RBI lowered its interest rates to tackle the global meltdown keeping in line with a worldwide decline in interest rates. Barring this phase from 2008 to 2010, the RBI has maintained a tight monetary grip on the economy, and this is true especially of the post-2010 period. This was a time when India was reeling under price rises. Food inflation has been a major part of the overall inflation level. In 2012-13, food inflation has been mostly driven by the high price of cereals and recently the high price of onions and hike in diesel prices has put further pressure on the inflation level. The RBI in a bid to cool down prices raised the policy rate from 5.25% to 8.5% hoping to limit liquidity.

As the nature of inflation was structural, monetary tightening failed to have any real impact on prices. At 8%, India maintains one of the highest policy rates in the world at the moment. While a rise in interest rates has not had much impact on prices, growth has suffered, with the latest growth rate projection being lowered to 4.9%. Now that inflation does not seem to be heading off and growth is steadily plummeting, the fear of stagflation is looming. While inflation is often the result of an overheating economy, in India, it is marred by supply side issues. Perennial infrastructure problems, persistently inadequate electricity generation and a fall in the value of the rupee making imports like crude oil more expensive has added to the inflationary pressures in the country. Manufacturing continues to suffer as the IIP growth rate fell to a six-month low of 2.1% in December last year. Besides having a weak manufacturing sector, the rise in the cost of borrowing due to constant interest rate hikes has only aggravated the fall in the growth figures for the country. This impending stagflation can be improved by moving away from a monetary policy solution to a fiscal policy solution.

A tight monetary policy also resulted in loans becoming dearer for industries leading to a downward spiral of investments by the private sector in the past few years. According to the Economic Times Intelligence Group, the rate of capital investment growth marked its lowest in 2012. The gross asset formation of a sample of 1,058 listed companies rose by 12.3% in FY12 compared to 34% and 26% in FY07 and FY08. With India’s private sector reluctant to commit to big ticket projects, thanks in part to the high cost of funds, the stated goal of attracting a trillion USD of investments in the sector might well remain unfulfilled. At a time when more than 12 million people enter the Indian workforce every year, it would be impossible to provide employment to these youth if investments don’t pick up. And high unemployment has historically been a recipe for social disaster.

On the fiscal front, the fiscal deficit of the economy stands at 4.8% of the GDP and is on the verge of being pushed over 5%. The slowdown in growth, widening CAD and depreciation of the rupee against the dollar has led to the worsening of the fiscal situation. On the expenditure side, subsidies have put a huge burden on the deficit. Prudent expenditure in fertilizer and petroleum subsidies is crucial. The government also needs to redirect its focus from schemes that have inadequate capital formation like MNREGA and instead should focus on creating a better infrastructure for the poor through the Direct Benefit Transfer schemes. Therefore, it is important to tackle the problem from both sides - demand and supply in order to achieve the balance between growth and inflation.

Supply side measures include ramping up the cold storage infrastructure. Currently, India wastes fruits and vegetables worth 13,300 crores every year due to a lack of refrigerated transport. To that end, FDI in food retail might just help create the much-needed cold storage infrastructure in India and reduce the menace of middlemen - the cause of much of the artificial price rise witnessed.

The Indian economy is also impaired by constant corruption and illegal arbitrage whether it was the Coal India scam or the selling of kerosene at market prices obtained through subsidies. The root cause for India’s poor macroeconomic performance is not the policies formulated but rather poor implementation of these policies. It is important to address the cause for lack of implementation in order to find a solution. Better policies and their proper implementation is now imperative which can be achieved through better governance and curbing corruption.

Inflation targeting has become a bone of contention in India. Many economists agree that a certain level of inflation is a necessary evil. Many also argue that the RBI’s target is extremely low and would require monetary tightening and high rates of interest -- the brunt of which would be borne by growth. A balance is needed between fiscal and monetary policy in order to improve the macroeconomic health of the economy.

(The writers are Research Interns at Observer Research Foundation, Delhi)

The views expressed above belong to the author(s). ORF research and analyses now available on Telegram! Click here to access our curated content — blogs, longforms and interviews.