Time for a rethink on monetary policy: Has inflation targeting failed?

What is the probability of the Reserve Bank of India Governor Shaktikanta Das having to write to the government as to why the Monetary Policy Committee failed to contain inflation as prescribed in the Act?
With inflation as measured by the Consumer Price Index soaring to a 64-month high after more than three years of the MPC obsessing with it, questions are being raised about the efficacy of the conservative policy approach.

Inflation advancing to a multi-year high could not have come at a worse time for the monetary policy hawks where the growth lobby is blaming the high interest regime, to cap price pressures, for collapsing the economic growth rate as well.

Conservative policy prescription of economists as the panacea for Indian economic ills of persistently high inflation and recurring bouts of currency slide is under threat with the country neither having low inflation, nor a sustainable growth rate.

When the Modi government signed off on inflation targeting as a monetary policy objective, it was hailed as the step towards moving the economy to global standards. Does it need a review?

“The term of the committee is coming to an end next year. So it may be a good time to review the objectives,” says A Prasanna, head-fixed income research, ICICI Securities Primary Dealership. “They can form a committee to examine the MPC mandate. A rigid centre point of 4% is the problem. They can consider either changing the band or narrowing it for more effective policy making.”

In 2016, the government constituted the MPC with three members from outside of the RBI with a mandate to contain inflation at 4%, but within a range of 2 percentage point on either side, widening the window between 2% and 6%. It also said if the MPC fails to keep price rise in this band for three consecutive quarters, the governor would be obligated to write to Parliament as to why it failed and how it could achieve the target.

At that point, it chose the CPI as the target discarding the Wholesale Price Index, which was looked up to till then for the state of price pressures in the economy.

Stagflation or not?
When the government was presented with a dilemma as which one to follow, the expert opinion leaned towards the CPI given that a majority of Indians’ spending basket comprised food items. WPI was junked since manufacturing items did not touch the common man much.

CPI for December climbed to 7.35%, its highest level since 2014, and a long way away from the predictions of most of the economists. This one coming at a time when the statistical office is projecting the economy to expand just 5% for the current fiscal, an 11-year low.

It is leading to debates whether India is facing stagflation. It is a state of the economy where price rise is sharp and economic activity is slumping.

“Stagflationary conditions will be temporary, underpinned by our expectation that supply-side pressures will soon subside and the consumption shocks will further depress core inflation,” says Sonal Varma, economist at Nomura Securities. “This phase however is likely to be transitory.”

This state of the economy and its accompanying theories came first during the 1970s in the US mostly due to the so called ‘oil shock’. It turned on its head the prevailing belief that high inflation is good for the economy because it led to higher employment. Subsequently, Federal Reserve Chairman Paul Volcker had to raise interest rates to as high as 20% to rein inflation.

Most central banks across the globe adopted inflation targeting as a key objective as the thinking that price stability is a key for sustained economic growth gained currency.

But the question is whether Indian situation is similar to what the US faced in the 70s?

“Stagflation comes with high oil prices which is not the case here,” says Prasanna of ICICI. “The problem here is due to onion which is a short-cycle crop. At best, it’s stagflation for a quarter.”


Food vs manufacturing
In the current bout of inflation, it is the food prices, especially onions, that have caused the trouble and it is not spread across the spectrum and there is unlikely to be any second order effect like a spillover.

Food accounted for lion’s share of headline inflation last month with it contributing 560 basis points, or 75%, of total headline inflation despite its weight in the CPI basket being about 46%.

“This begs the question, when will headline CPI inflation peak? Our base case has been December itself with onion prices retreating,” says Indranil Sen Gupta, economist at Bank of America Merrill Lynch.

The opponents of inflation targeting have blamed the choice of the index saying that food prices-heavy CPI is a wrong gauge as interest rates hardly have any impact on food prices.

An argument is that with food prices driving inflation, monetary policy is a weak tool to control prices. Because prices of food is more driven by supply-side factors rather than demand. Monetary policy is effective in impacting demand, especially industrial goods and services and not food prices.

But those who argue in favour point out that much of the food price rise gains are pocketed by the middlemen who are part of the services industry, and those gains do not reach the farmers after all. It is also an irony that the rise in food prices is pocketed more by services. Without reforming the agriculture sector policy measures, monetary policy may not achieve the objective.

“There is consensus that improvement in the supply chain could become a major channel for promoting inclusive growth, as this can increase the share of farmers in retail prices paid by the consumers,” Governor Das said recently. “The average share of farmers in retail prices of major primary food items varies between 28% and 78%. It is lower for perishables and higher for nonperishable items.”

The policy stance
While critics may say that the MPC was wrong in lowering interest rates by as much as 135 basis points in less than a year, the MPC committee most likely saw this coming. In the last policy in December, it flummoxed the market by maintaining the status quo in rates when the unanimous expectation was for a quarter point reduction.

With inflation reading well above the target band, even the most optimist among the economists are pushing back on their expectations for the next rate cut.

“We believe the RBI will continue to stay on hold during this period of stagflation,” says Varma of Nomura Securities. “The strategic retreat of monetary policy activism amid falling growth shifts the focus to the government’s policy guidance in its February 1 Union Budget.”

Yet another factor in inflation is the government spending. When price pressures accelerated between 2010 and 2014, it was blamed on excessive government spending on welfare schemes and higher support prices for farm products.

In fiscal 2020, the government may breach the fiscal deficit target of 3.3% of the gross domestic product due to lower revenue growth. Many economists are penciling in a 50-basis points breach and another miss next year too.

“A slippage in fiscal 2020 deficit target is widely expected amidst weak growth and a corporate tax rate cut,” says Anubhuti Sahay, economist at Standard Chartered Bank . “Thus focus is likely to remain on how the government reverts to fiscal consolidation and lower level of debt over next few years.”

Amid worries about both food prices-driven inflation and fiscal deficit getting out of control, there’s a silver lining – the temporary nature of farm products price spike and the absence of broad-based price pressures.

“The contemporary pressures on inflation are essentially supply driven, and are likely to moderate after the first quarter, easing headline inflation closer to 4.5% in the second and to a sharply lower 2 to 2.5% in the fourth quarter,” says Varma of Nomura.

If Consumer Price Index rose 7.35% in December, wholesale prices went up by just 2.59%.

Governor Das may not have to write a letter if prices behave as economists expect, but the government which has to reconfigure the MPC by March 2021 may consider a review.