Comment on “Indian Monetary Policy in the Time of Inflation Targeting and Demonetization”

Abstract

Mohan and Ray ( 2019 ) describe and evaluate Indian monetary policy from 2008 to 2017. One of the major events during this period was India's adoption of a flexible inflation targeting (FIT) framework in 2015. Mohan and Ray, however, are skeptical about the virtue of FIT in India. I will argue against their skepticism. Mohan and Ray ( 2019 ) argue that India's monetary policy with a “multiple indicators approach” was working well from mid‐1990s to 2009, but that monetary policy between 2009 and 2013 allowed consumer price index inflation rate to rise to a double‐digit level. It was likely that the stimulus to avoid spillovers from the Great Recession was overdone. The high inflation episode induced an interest in FIT among some policy‐makers in the government and academics, but not in the Reserve Bank of India (RBI) according to Mohan and Ray. The movement toward FIT started in 2013 when the Report of the Committee on Financial Sector Reforms chaired by Raghuram Rajan recommended its adoption. At that time, the RBI was not enthusiastic about FIT: First, India had moderate inflation, with the 2009–2013 period being viewed as an exception. Second, inflation targeting requires an efficient monetary transmission mechanism and efficient financial markets without interest rate distortions, which India did not have. Third, inflation pressure came mostly from energy and food. Targeting a core inflation rate in a low‐income country would not have much relevance to the standard of living. In September 2003, Rajan became Governor of the RBI and steered the Bank toward accepting inflation targeting. He immediately asked Deputy Governor Patel to form a panel to come up with suggestions to strengthen the monetary policy framework. The Patel Committee submitted its report in January 2014, recommending inflation be used as a nominal anchor. It took more than 1 year, but the Government of India and the RBI signed the Monetary Policy Framework Agreement in February 2015 – this is the formal adoption of FIT in India. It contained the target of bringing down the inflation rate to below 6% by January 2016; below 4% for fiscal year 2016–2017; and for all subsequent years 4% plus/minus 2%. This was a plan for a disinflation glide path. The actual inflation rate followed the disinflation glide path and has stayed in the specified range. The FIT has been very successful. Mohan and Ray emphasize that the success is due to elements of good luck, such as a declining discretionary component of minimum support prices, declining crude oil prices, and exchange rate movements. Mohan and Ray also believe that the transmission of monetary policy in India is slow and incomplete. They caution that as commodity prices go up, the RBI will have a difficult time meeting the target. I hold a positive view concerning India's adoption of a FIT framework. In general, FIT has at least three benefits. First, it helps to anchor inflation expectations at the target rate. When a demand or supply shock forces the inflation rate to deviate from the target, anchored inflation expectations will give the central bank wider options. Second, the FIT framework is not a single‐minded policy framework for inflation. FIT is supposed to minimize the weighted sum of the deviation in employment (or growth) from its target and that of inflation. Third, FIT works as a “heat shield” against political pressure. With the FIT agreed between the central bank and the government, as in India, the government is also committed to the low and stable inflation rate. When the goal is agreed and the instrument is independently chosen by the central bank, it is difficult for the government to disagree with the central bank. In India, it is not inconceivable that faster growth in the near future may make it necessary for the RBI to raise the policy rate. FIT would make it possible for the RBI to implement its policy choice with much less conflict. In implementing FIT properly, a central bank has to have a good forecasting model and aim at hitting the target 12–18 months later, because of the slow transmission of policy to the economy. In the forecasting model, many macro variables should be used. In that sense it should be a “multiple indicator approach.” It may be the case that the RBI was practicing FIT even before 2009 without announcing it. If so, announcing it only opens up the other benefits mentioned earlier. Supply shocks in food prices and energy prices are well‐known problems in conducting FIT. However, those prices never continue to go up forever. Food and energy prices tend to go up and down. FIT will aim at keeping the target as an average rate over the medium term. The headline inflation rate is fine to target with an allowable deviation band, just as in the current case of India. In 2015, India has become the latest country in emerging market Asia to adopt a FIT framework following Korea, Thailand, Indonesia, and the Philippines. It is likely that India will practice and improve its FIT with experience, just as other Asian FIT countries have done so.