India’s inflation targeting regime is once again in the spotlight as consumer price index (CPI) inflation has surged in December to 7.5%, on an annualised basis — well above the upper limit of the target range of 2-6%. If it persists for two quarters at this level, the Monetary Policy Committee (MPC) is obliged to act to bring it down by tightening monetary policy.
But with core inflation declining in Q3, 2019-20, and nominal GDP growing by only 7-8%, is inflation targeting — which gives primacy to fighting inflation over growth or employment — right for India, and does it focus on the right target?
The Pulse of the Cereal
We again see that it’s a temporary surge in food and fuel prices that has driven inflation up. Among food items, an onion price surge was due to supply shocks that are now being contained by larger imports. The surge in cereal prices is primarily due to a huge procurement drive prior to elections but inexplicably slow release of the procured grain leading to higher prices. For pulses, unnecessarily large imports a year ago depressed prices and led to the reduction of pulse cultivation, and now to higher prices in a typical cobweb pattern that bedevils the farm sector.
The surge in petrol and gas prices was linked to tensions in West Asia that bumped up global oil prices. Fortunately, at least for now, those tensions have abated. But India clearly needs to reduce oil dependence and also set up an oil reserve to mitigate these surges.
Monetary policy, however, will not solve any of this. And any increase in repo rates to tighten monetary policy will make things worse, not better. Moreover, the decline in inflation came about not due to tight money, but was part of a global commodity cycle that saw a huge decline in international oil and food prices. Cereal prices fell over 60% between 2011 and 2016, and overall food prices fell 40% in that period. Oil prices fell even more sharply from $108 a barrel in early 2013 to $27 a barrel in early 2016.
The decline in inflation had very little to do with tighter monetary policy, with high real repo rates that only hurt growth. In developing countries, the principal factors driving inflation are domestic supply shocks and imported inflation. Monetary policy can, at best, play a supportive role. In any case, at best, it can affect core inflation, not headline inflation.
To allow for equal focus on growth, some have suggested targeting nominal GDP instead of inflation. India’s nominal GDP growth has now fallen to around 7.5% from highs of 1214% a few years ago. The last Budget assumed nominal GDP growth of 12%. Even with rising inflation, nominal GDP growth will not even reach 10% in 2019-20.
But the problem with using nominal GDP growth as a target is that its composition matters. A nominal GDP growth with 4% real growth and 8% inflation is very different from one with 8% real growth and 4% inflation. Targeting nominal GDP makes no distinction between those two scenarios.
A more constructive approach for emerging economies — where food and fuel prices can be volatile — is to target core inflation. Core inflation is not subject to volatile movements. Monetary policy also has an impact on it, with a lag of four-five quarters. Core inflation is also more reflective of overall demand conditions than are food and fuel prices.
A Case of Inflated Inflation
Core inflation declined in the first half of 2017 post-demonetisation, but then rose again as demand picked up after remonetisation and the consumption bump India saw in 2018.
But, in 2019, as demand flagged, core inflation also dropped, partly also due to lagged effects ofhigher interest rates in 2018. The real repo rate with CPI inflation has now turned negative — ensuring that the MPC in February will be unable to lower rates, and may even have to raise them despite slowing growth. If core inflation were the target, then the real repo rate remains high and is, in fact, rising despite lower repo rates. Then further cuts in the repo rate may well be on the agenda for the upcoming MPC meet by at least 15 basis points (bps).
India must rethink its inflation targeting regime. It has not been the main factor driving inflation up or down. If anything, it has allowed interest rates to remain too high. It is not the only reason for high interest rates — India’s decrepit banking system, laden with non-performing assets (NPAs); continued use of statutory liquidity ratios (SLRs), which are scheduled for a marginal reduction from 19.5% to 18% on April 1, 2020; and administrative-directed lending, all of which together have kept intermediation margins — the difference between lending and deposit rates — as high as 550-600 bps.
But the way inflation targeting has been used in the past has kept interest rates between mid-2014 and mid-2018 at around 250 bps, at least 100 bps higher than they should have been. This has kept the exchange rate overvalued by 10-15%, encouraging imports and hurting exports. It has also dampened demand and lowered overall growth.
In 2019, the RBI governor has followed a more pragmatic approach. But with food and fuel CPI surges again exposing its absurdity, it’s time to rethink the inflation target regime itself. If you have to keep it, at least focus on the right target — core inflation rather than CPI inflation.
The writer is chief economic adviser, Federation of Indian Chambers of Commerce and Industry (Ficci)