India May Be Moving Toward Inflation Targeting: Andy Mukherjee
July 27 (Bloomberg) -- Two innocuous press statements this month provided ample
clues that central banking in India may be heading for a transformation.
The makeover will probably lead to inflation targeting -- a system under which
the government's control over monetary policy is limited to giving the Reserve
Bank of India a price objective.
The first indication of change came July 8 when the bank announced that it had
set up a so-called technical advisory committee on monetary policy.
Then, on July 19, the central bank said that the six-person panel, consisting
mostly of academics, had met for the first time. That was just a week before
Governor Y.V. Reddy announced his decision to leave key interest rates
unchanged.
The panel was conceived in a slightly different format five years ago by a
central bank advisory group, which also recommended that India adopt a single
inflation target set around a three-year average rate.
``Once the single objective is set out, the remit of the monetary policy
committee would be clear and the Reserve Bank of India should be given
unfettered instrument freedom and held fully accountable for attaining this
objective,'' the advisory group on monetary transparency said in September
2000.
It doesn't appear to be mere coincidence that S.S. Tarapore has been named on
the monetary policy advisory committee. He is a former Reserve Bank deputy
governor who was on the group that recommended adoption of inflation targeting.
Inflation Targeting
Fifteen years after New Zealand became the first country to formally accept
price goals as the primary objective of monetary policy, inflation targeting
remains a hotly debated issue, and not just in developing countries like India.
Opinion is divided in the U.S. too, where Ben Bernanke, the chairman of White
House Council of Economic Advisers, is the leading proponent of inflation
targeting at the Federal Reserve.
Alan Greenspan, the Fed chairman who retires in January, prefers the Fed's
current flexible approach.
Since the 1997 Asian crisis, many Asian countries, including South Korea, the
Philippines, Thailand and Indonesia, have adopted inflation targeting regimes.
The rationale is that few central banks can expect to gain credibility for
their monetary policies without the help of a nominal anchor. Small open
economies such as Hong Kong can peg their exchange rates. For the rest,
announcing an inflation target and then achieving it is preferable to trying to
hit an intermediate goal such as money supply.
As for jobs or economic growth, those targets are best left to the government.
Roadblocks
It's easier said than done.
In India, where the federal and provincial governments run chronic budget
deficits amounting to about a 10th of gross domestic product, it willy-nilly
becomes the central bank's duty to raise cheap money for state spending.
That leads to political pressure on the Reserve Bank to keep interest rates
lower than might be needed to counter inflation.
The Indian government, in its annual assessment of the economy in 2002,
acknowledged that it was difficult to make the central bank chase an inflation
target because ``the debt management function gets inextricably linked with the
monetary management function while steering the interest rates.''
Autonomy and Transparency
As Indian central bank Governor Reddy said in a February speech: ``The
prerequisites for inflation targeting include a considerable degree of
operational autonomy or independence for (the) central bank, flexible exchange
rate conditions, well- developed financial markets and absence of fiscal
dominance.''
All four elements are slowly falling into place. As far as fiscal dominance is
concerned, India now has a law that requires the government to pare its budget
deficit.
The stock market is functioning well, while the bond market is a work in
progress. Now that China has taken a first step to a more flexible yuan, India
too may be emboldened to allow its ``managed'' exchange rate to creep up toward
the rupee's purchasing power parity.
In a democracy, further operational autonomy for the central bank is impossible
without it agreeing to become more transparent. That's where a monetary policy
committee comes in.
Inflation Hawk
In the U.S. or the U.K., where committee members vote on interest rate
decisions, the minutes of meetings become a signaling tool for the market.
Reddy, however, must use the newly constituted technical group only as a
sounding board. It may be premature to let the market seek policy guidance from
a group that's yet to become an instrument of collective decision-making.
Still, it's important to note that India may have begun a crawl toward
inflation targeting. The change, when it arrives, won't have come a moment too
soon.
After all, pressure for price increases is inevitable in an economy where the
government wants to lift the rate of annual gross domestic product growth to
between 7 percent and 8 percent from the past three years' average of 6.5
percent.
When the government allows state-owned refiners to raise retail gasoline prices
to bring them in line with international levels, the current inflation rate of
4.1 percent may shoot up again, as it did in August 2004 when it came close to
9 percent.
For the party to continue, India needs a central bank that has credibility as
an inflation hawk.
The country also needs a better price gauge. The current index doesn't capture
price movements in services, which now account for more than half of India's
economy. It'll be useless to target inflation without knowing how to measure
it.
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