Today'sPaperOPINION

Understandinginflationtargeting
C.Rangarajan

Inflationtargetingisbackinthenewsandthisiswelcome.Ihavealwaysheldtheviewthatthedominantobjectiveof
monetarypolicyisthemaintenanceofpricestability.Inflationtargetinggivesprecisiontotheconceptofpricestability.
Inanymonetarypolicyframework,akeyingredientisanenunciationofitsobjectives.Thisaspecthasassumed
increasedsignificanceinthecontextofthestressbeinglaidontheautonomyofcentralbanks.Autonomygoeswith
accountability,andaccountabilityinturnrequiresaclearstatementofgoals.
Thecaseofpricestabilityasthemajorobjectiveofeconomicpolicyrestsontheassumptionthatvolatilityinprices
createsuncertaintiesindecisionmaking.Risingpricesadverselyaffectsavingswhilemakingspeculativeinvestments
moreattractive.Theseapart,thereisacrucialsocialdimension,particularlyindevelopingcountries.Inflation
adverselyaffectsthosewhohavenohedgesagainstit,andthisincludesallpoorersectionsofthecommunity.Thisis
indeedaverystrongargumentinfavourofthemaintenanceofpricestabilityinemergingeconomies.
Pricestabilityandgrowth
Acrucialquestionthatarisesinthiscontextiswhetherthepursuitoftheobjectiveofpricestabilitybymonetary
authoritiesunderminestheabilityoftheeconomytoattainotherobjectivessuchasgrowth.Inshort,thequestionis
whetherthereisatradeoffbetweeninflationandgrowth.Thereisageneralconsensusthatoverthemediumandthe
longterm,thereisnosuchtradeoffandanenvironmentoflowinflationismostconducivetofastereconomicgrowth.
However,therecouldbesuchapossibilityintheshortterm.Byinjectinggreaterdemandandtherebygenerating
higherinflation,highergrowthmaybeachieved.However,tosustainthisgrowth,theauthoritiesmayhavetogenerate
higherandhigherinflation.Thiswillendupasaselfdefeatingexercise.
Whatthenisthetolerablelevelofinflation?Atverylowlevelsofinflation,theremaynotbeanyadverseconsequences
ontheeconomy.However,ineveryeconomy,givenitsstructure,thereisalwaysacertainlevelofinflationbeyond
whichcostsofinflationbegintorisesteeply.Itisthisinflationthresholdwhichcanprovideguidancetopolicymakers.
Interestingly,theChakravartyCommittee,ofwhichIwasamember,regardedtheacceptableriseinpricesas4per
cent.SeveralstudiesintheIndiancontexthaveestimatedthatthethresholdlevelofinflationmaybearound6percent.
Otherobjectives
Questionshavebeenraisedabouttherobustnessofsuchmodels.Evenlargeeconometricmodelsarenotinaposition
tocaptureallthecostsofinflation.Thisorderofinflationishoweverhigherthanwhatdevelopedcountriesnormally
aimfor.ThiswillhavesomeimplicationsfortheexchangerateofthecurrencyandCurrentAccountDeficit.Inthe
Indiancontext,itisbesttoworktowardsanaverageof4percentandtakestrongactionifittouches6percent.This
willamounttoinflationtargetingwithaband,asrecommendedbytheUrjitPatelCommittee.Suchacommitmentwill
alsodampeninflationexpectations.
Doesthefocusoninflationtargetingbymonetaryauthoritiesmeananeglectofotherobjectivessuchasgrowthand
financialstability?Hardlyso.Whatinflationtargetingdemandsisthatwheninflationexceedsthethresholdlevel,the
primaryfocusofmonetarypolicymustbetobringitbacktothedesiredlevel.Itissometimesclaimedthatthefinancial
crisisof2008intheUnitedStatesandwesternEuropesoundedthedeathknellforinflationtargeting.Thereis
continuingdebateonwhetherthecrisiswasprecipitatedbymonetarypolicyfailureorregulatoryfailure.Countrieslike
CanadaandAustralia,whichwerecommittedtoinflationtargeting,werenotcaughtinthecrisis.
Centralbankshavemultiplefunctions.Apartfrommonetarypolicy,regulationofthefinancialsystem,particularlythe
bankingsystem,isentrustedtocentralbanksinmostcountries.Therehastobeclosecoordinationbetweenthesetwo
functions.Forthecrisisitself,regulatorylapseshavetotakemajorresponsibilitywhilemonetarypolicyinthese
countriesmightatbesthaveplayedafacilitatingrole.Thelowinterestrateregimewhichprevailedbecauseoflow
inflationcouldhavecreatedanenvironmentfavourableforhighrisktaking.Ariseinassetpricesshouldhavealerted
themonetaryauthoritiesandtheyshouldhavetakenappropriateaction.Inflationtargetingdoesnotprecludeother
objectivesfromthepurviewofmonetaryauthoritiessolongasinflationremainswithinthecomfortzone.Thecontrol
ofinflationbecomesitsexclusiveconcernonlywheninflationcrossestheacceptablelevel.
Canitbedone?
CantheReserveBankofIndia(RBI)orforthatmatteranycentralbankeffectivelyimplementaninflationmandate?
Dotheyhaveenoughinstrumentstoachievethegoal?Theabilityofthecentralbankstocontrolinflationwhensuch
inflationstemsfromexcessdemandisnormallyconceded.Itiswheninflationistriggeredbysupplyshocksthatsome
doubtsareraised.SuchsupplyshocksaremostcommonincountrieslikeIndiawhereagriculturalproductionissubject
tothevagariesofnature.Evenwheninflationistriggeredbyfoodinflation,monetarypolicyandfiscalpolicyhavea
roletoplay.Iffoodinflationlastslong,itgetsgeneralised.Wagesriseleadingtoageneralcostpushinflation.Ifhead
lineinflationexceedstheacceptablelevel,monetarypolicymustactatleasttoensurethatthereturnonfinancialassets
ispositiveinrealterms.Inasituationofsupplyshocks,itmaytakelongerformonetarypolicytobringdowninflation.
Therecentexperiencewithinflationinourcountryisagoodexampleofthis.Thatiswhytheinflationmandatemust
provideforarangeandatimeframeforadjustmentwhichshouldnotbetooshort.Nevertheless,monetarypolicymust

actirrespectiveofwhattriggeredinflation.Obviously,supplysidemanagementisneededinsituationsofsupplystock
andthatshouldbetheresponsibilityofthegovernment.
Institutionalframework
Theappropriateinstitutionalframeworkforimplementingtheinflationmandatealsoraisescertainquestions.Thefirst
issueisonwhoshoulddeterminetheacceptablelevelofinflation.Inmostcountrieswhichhaveadoptedinflation
targeting,thetargetissetbythegovernmentorParliament.Thisappearstobeappropriateinasmuchasthe
acceptablelevelofinflationisnotpurelyaneconomicissue.However,onceamandateisprescribedbythegovernment
orParliament,themonetaryauthorityshouldbeleftwithfullautonomytousewhateverinstrumentsthatareavailable
toittoimplementthemandate.
Thesecondissuerelatestoanappropriatepriceindexwhichshouldbeusedtomonitorinflation.InIndia,wehave
monitoredinflationbymostlylookingatthewholesalepriceindex.Thatwasbecauseoftheeasyavailabilityofthis
index.Untilrecently,wehavehadnocompositeretailpriceindex.Sincetheobjectiveofinflationtargetingisto
minimisetheimpactofpriceriseonpeople,theappropriateindexwillberetailinflation.
Thethirdissuerelatestoinstitutionalarrangementswithinthemonetaryauthoritytotakepolicydecisionsconsistent
withaninflationmandate.Inseveralcountries,atechnicalmonetarypolicycommitteeisconstitutedwithmembers
drawnfromthecentralbank,fromthegovernmentandfromoutsideexperts.Mypreferencewouldbetoconstitutea
committeeoftheboardoftheRBItodothis.ThisiswhatwasdonewhentheBoardforFinancialSupervisionwasset
up.WhileconstitutingthecentralboardoftheRBI,thisaspectoftheworkofthebankmustalsobekeptinview.
Inflationtargetingreemphasisestheprimacyofpricestabilityastheobjectiveofmonetarypolicy.Giventherigidities
intheeconomyandthelagsinpolicyimpact,itmustbeoperatedwithflexibility.
(Dr.C.RangarajanisformerGovernoroftheReserveBankofIndia.)
Apartfrommonetarypolicy,regulationofthefinancialsystem,particularlythebankingsystem,is
entrustedtocentralbanksinmostcountries.Therehastobeclosecoordinationbetweenthesetwo
functions.
Inflationtargetingreemphasisestheprimacyofpricestabilityastheobjectiveofmonetarypolicy.
Giventherigiditiesintheeconomyandlagsinpolicyimpact,itmustbeoperatedwithflexibility