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Inflation targeting without leash on competitive populism would fail

MARCH 19, 2014

By TIOL Edit Team

THE ever-burning issue of inflation control is lately getting a new direction. Finance Minister P. Chidambaram and Reserve Bank of India (RBI) Governor Raghuram Rajan have jointly struck the chord of inflation targeting, an approach that the Government has so far avoided.

The other day Mr. Chidambaram endorsed Mr. Rajan's recent suggestion that Parliament should fix inflation target for RBI. At a press conference jointly addressed by the two stalwarts, Mr. Chidambaram reportedly stated: "when the RBI head said that the government through Parliament will set an inflation target and leave the regulator to find ways and means to achieve that target. I think that is the correct approach."

The approach is no doubt correct. It, however, should not become an excuse for cover-up of the competitive populism-led inflation that UPA Government has promoted to the hilt. Asking Parliament to set an inflation target is like expecting the incoming Government (which would in all probability be a non-UPA one) to put back the released genie back into the bottle.

An important element of UPA genie are double-edged commitment on food security - first through statutory right for the masses to relish highly subsidized food and the second through the underlying compulsion to either import food or regularly provide remunerative prices to farmers to keep the yield curve up. Another element of genie is the decision to set up 7th Pay Commission, whose recommendations would stoke fires of inflation two years hence.

If the Government can change merrily fiddle with fiscal and revenue deficit by amending the Fiscal Responsibility and Budget Management Act (FRBMA), it can also conveniently alter inflation target in the similar manner. Inflation targeting must not become a buck-passing game for the Executive that lacks spine to stand up against unsustainable level of populism, which is showing its true colours in the run-up to the Lok Sabha polls.

Inflation targeting should be preceded by hammering of a consensus in the political class on the limits of populism, which is threatening the long-term economic growth and indeed survival of the country. Directive Principles of the Constitution should not be flaunted to rationalize freebies and other fiscally-straining promises made during the elections.

Inflation targeting is, however, a good approach to tame runaway rise in prices that has eroded rupee's value, savings and economic growth for last several years, apart from increasing poverty and blunting India's economic competitiveness.

Both the supporters and critics of inflation targeting have been articulating their views ever since a committee set up by RBI advocating this approach in January this year under the chairmanship of RBI Deputy Governor Dr. Urjit R. Patel.

This ‘Expert Committee to Revise and Strengthen the Monetary Policy Framework' has recommended a phased adoption of inflation targeting.

It stated: "In view of the elevated level of current CPI inflation and hardened inflation expectations, supply constraints and weak output performance, the transition path to the target zone should be graduated to bringing down inflation from the current level of 10 per cent to 8 per cent over a period not exceeding the next 12 months and 6 per cent over a period not exceeding the next 24 month period before formally adopting the recommended target of 4 per cent inflation with a band of +/- 2 per cent. The Committee is also of the view that this transition path should be clearly communicated to the public."

This target appears judicious as it implicitly factors in the fact that moderate inflation is unavoidable for a country that must grow rapidly and endlessly to provide jobs, reduce poverty and generate wealth for multiple purposes.

The recommended inflation target appears to converge with inflation threshold, which economist consider as a point of inflexion for the growth-inflation trade-off.

It is here pertinent to quote a RBI working paper captioned ‘Inflation Threshold in India: An Empirical Investigation' issued in September 2011.

It says: "Empirical results suggest that there exists statistically significant structural break in the relation between output growth and inflation in between 4.0 and 5.5 per cent of inflation above which inflation retards growth rate of GDP and below the threshold level, there is a statistically significant positive relationship between inflation rate and growth. Thus substantial gains can be achieved if inflation is kept below the threshold."

Inflation targeting as an objective of monetary policy can only work if the Central and State Governments allow efficient inter-play of market forces, removes all supply constraints and promotes efficiency across all value chains.

As put by Urjit Patel Committee, "administered setting of prices, wages and interest rates are significant impediments to monetary policy transmission and achievement of the price stability objective, requiring a commitment from the Government towards their elimination."


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