Inflation targeting and a bit of Malice in Wonderland

Alice: Would you tell me, please, which way I ought to go from here?

The Cheshire Cat: That depends a good deal on where you want to get to.

Alice: …So long as I get somewhere.

The Cheshire Cat: Oh, you’re sure to do that, if only you walk long enough.

Lewis Carroll, Alice in Wonderland

India has taken a bold monetary step, perhaps the boldest post-reforms, in introducing a soft inflation targeting regime in the country. This pushes us into the list of more developed economies like the US or the Eurozone, which have been traditional inflation targeting hubs.

There have been immediate reactions, typically, on both sides of the argument. Moody’s, the moody ratings agency, has announced that this new Monetary Policy Framework (MPF) is a credit positive and will apparently go a long way in steadying the economy. Why? Because, steady prices are a pre-cursor to growth. On the other hand, the erstwhile RBI Governor Dr. Subbarao gave a statement that inflation targeting is “neither feasible nor advisable” in India.

Who is right? Now, as usual, there is no one answer to this conundrum. (Curioser and curioser! cried Alice) But the conundrum arises because of the following history.

Typically, the fabric of the fiscal-monetary relations in India has been that the fiscal policy is oriented towards the growth-employment outlook whereas the monetary policy does that tight rope multi-dimensional balancing between inflation, growth, credit cycles, and obviously, exchange rates. Whew!

Under the new policy framework however, the RBI will have to mainly target inflation “with an eye on growth.” The mandate has been defined. The tone seems to be: If the Government of India is ready to deliver on fiscal consolidation and promises to deliver no more than 3% of the GDP as the fiscal deficit target, why should the RBI not be ready to deliver on inflation?

Can it? I am giving some of my misgivings below; I do hope that the guidelines will give us some clarity on all of these.

Fiscal consolidation is necessary, not sufficient:

The first issue that has been troubling my mind is whether fiscal consolidation is both necessary AND sufficient to control inflationary levels in India. While it is definitely necessary, I am a little reluctant to agree that its sufficient. A quick look in recent history suffices.

While it’s true that high fiscal deficits have generally been succeeded by high inflation levels, it is not necessarily true that higher inflation levels have ALWAYS been preceded by high fiscal deficits.

In the recent past, Indian inflation seems to have been imported and not really manufactured here, if you know what I mean. We imported food inflation from every trading partner, we imported oil inflation from the Middle East and we, finally, imported inflation straight from the heavens too, as the rain gods failed to deliver the goods 3 years out of 5 in a row. Now, neither food, nor fuel (both of which carry significantly high weightage in the CPI inflation index) prices are directly controlled or influenced by interest rates or any other monetary policy tool. Hence, one of the bigger challenges to inflation targeting in India will be the failure of the Monetary Transmission Mechanism to influence these two aspects of the CPI. Even if the RBI increases the rates and mutes the demand domestically, the country continues to sport high inflation numbers just because we keep importing them.

Thus, to say that with a commitment to a fiscal deficit target of 3%, India is now ready for inflation targeting seems a bit premature to me.

Steady inflation and risky asset markets

Now, there is a steep bit of history in this second point that has been bothering me. In the aftermath of the dotcom bubble bursting in the USA, the inflation figures were very benign (too soft as compared to the targeted rate). This prompted the then Fed Chief Alan Greenspan to push an easy money policy, that would create more demand and hopefully, more inflation. This easy liquidity, as many have pointed out since (including our very own RBI chief), was the chief culprit in causing asset price bubbles in the housing market, leading to huge overvaluations of the MBSs, CDOs and CDSs, which in its subsequent correction phase, caused major trauma and recession in the US.

Now, in India too, the inflation rates are currently extremely benign, thanks to the Saudi-Shale spat. The monetary policy framework mandates that the CPI be kept between 2% and 6% bands in the medium run upto 2017; it has been a long standing statement of the RBI Governor that an inflation rate of around 6% would be the RBI “comfort zone” to be achieved by January 2016. Now, the current movement of the CPI (around 5% inflation first week March) being lower than 6% implies that the RBI should begin work on an easy money policy; the recent repo cut by the inflation warrior stands testimony to the trend. In fact, there seems to be scope for further cuts till such a time that the CPI edges along to the targeted inflation. The only surprise element of the policy could well be the timing; again recent announcements have been made out of turn without really waiting for the mid-quarterly or quarterly reviews. Further, guidance on how low the oil prices may remain, how quickly the adjustment to the targeted 4% level is required and how well does a policy rate cut translate into a lending rate cut could well dictate whether the adjustment will be borne out of repo cuts or CRR cuts.

In the next couple of quarters hence, it does look like the RBI may push the Indian economy towards a softer rate regime; this also implies that the valuation of the asset markets (stocks, other financial segments, property) could well rise in the immediate couple of quarters. Once this gets factored in, the self fulfilling expectations game propels players or agents to buy, pushing the high valuation into an overvaluation zone. Are we already witnessing this kind of an overvalution on stocks? While I would be reluctant to say an unwavering, blanket “yes” to this question, the super spectacular rise in the P-Es of some companies (it is no secret that the current increase in Sensex has been valuation driven, rather than earnings driven) does indicate within the markets, some small “pockets” of overvaluation, for lack of a better word.

Thus, inflation targeting could well increase our vulnerability in terms of overvaluation of certain asset classes over the next one year. When the framework of the monetary policy gets defined, it would be important to state what stance the RBI would take on asset price volatility, even as it keeps the general price volatility intact.

Inflation targeting and exchange rate volatility

Door: Why, it’s simply impassible!

Alice: Why, don’t you mean impossible?

Door: No, I do mean impassible. (chuckles) Nothing’s impossible!”

The impossible trinity states that in the presence of fixed exchange rates and free capital flows, independent monetary policy cannot be practiced. Now, the moment we try our hand at inflation targeting i.e. the Central Bank practices independent monetary policy, exchange rates cannot really be kept fixed at all and would become more volatile. This phenomenon has been referred to as the “fear of floating” in quite a few research papers earlier. One of the biggest challenges of inflation targeting is that the Central Bank is mandated to control inflation through controlling interest rates. Now, at those interest rates, capital inflows or outflows may be triggered rendering the exchange rate and hence growth patterns and indeed, inflation itself, unsteady.

Fathom this. As the RBI stays committed to a low interest rate regime currently, FIIs are already moving in quickly into the bond markets, anticipating that the lower interest rates would drive up treasury profits through higher bond prices. Further, there is also anticipation of the easy liquidity helping the cause of a bullish market sentiment in stocks. What this effectively means is that the Indian exchange rate would start appreciating in the medium term.

I somehow do not see the RBI not reacting to changes in the exchange rate levels. I also am anticipating bigger movements in exchange rates in the coming year on account of corrections in oil prices and/or change in interest rates, or rumors thereof, in the US. Does a “flexible” inflation targeting also imply “flexible” exchange rate intervention? Will the RBI do a generic exchange rate monitoring or will it only do so if the deviations are “sharp”? Again, how sharp is sharp?

Constitution of the Monetary Policy Committee

Now, this is the most worrisome and politicized part of the story. Who will call the shots in the Committee that takes the decision on interest rates? If there is too much Government intervention errr…sorry….representation, there is always a danger that interest rate movements may get a political color rather than an economic one; something that will undermine the very thing we are trying to get done.

I, like others, await guidelines and hope that these issues do get addressed in those. Otherwise, as the inimitable Lewis Carroll says in Alice in Wonderland, we’d be forced to tell the RBI “You used to be much more….”muchier”. You’ve lost your muchness.”

 

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