Ajit Ranade: Inflation control has priority as RBI’s target

India has been following a swarm of central banks joining the ranks of inflation targeters, a trend that began in the 1990s. Under this policy, called flexible inflation targeting, the RBI had a mandate and a numerical target for an inflation range given by the government.

This was formalized as a contract between the RBI and the government, under which the RBI would be held responsible in case of deviation. The RBI also had an implicit dual mandate: High growth also had to be sustained, but price stability was a priority. This was repeated in the 2021 review of this framework.

However, recently voices have begun to come from both fronts. Does it make sense to give special authority to inflation targeting? Shouldn’t the numerical target for inflation exclude food and fuel items as their prices are volatile and beyond the control of RBI actions?

In this article, we will not dwell too much on the first issue of whether specific inflation targeting should be abandoned. Since the early days of central banking, maintaining the value of the currency or ensuring price stability has been the main focus.

Multiple mandates to ensure high growth and employment or rapid credit growth, a stable exchange rate and, more recently, general financial stability are also add-ons, and not all central banks sign up to them. Separate regulatory arrangements may be made for each of these additional objectives.

Even the central bank has separate departments to focus on exchange rate stability or financial markets. In addition, it has been determined that there is no trade-off between low/stable inflation and high growth in the medium and long term in the dual jurisdiction issue. In fact, the former increases the chances of the latter.

In the short run, tolerating higher inflation to produce higher growth is a Keynesian idea on which there is a weakening consensus. This is because the reward for higher growth fades when you take into account the role of people’s expectations about future inflation, or the impact of short-term growth caused by policies or inflationary financing of government spending.

Private investment is not excited by inflationary policy actions aimed at such short-term pumping.

There is a more nuanced debate on the second issue, about whether food and fuel should be excluded from the target inflation indicator. In developed countries, these variable components constitute a small share of total consumer expenditure. The reason for this is the high per capita income.

It is only recently that the average consumption basket’s share of food and fuel expenditure in India has fallen below 50%. How can you exclude almost half of the basket when the task is to ensure general price stability? Food inflation tends to rise due to supply shocks such as climate events or movements in oil prices.

Because food demand is relatively inelastic and supply cannot increase overnight, prices are rising rapidly. However, due to low per capita income, the food budget affects general expenditures. Inflation in food prices can also put pressure on wages, causing an inflationary cycle.

Monetary policy cannot ignore such movements, even if they are caused by short-term events. This policy aims to stabilize inflationary expectations, and for most Indians, the perception of inflation is shaped by the prices of food and fuel, which are daily necessities.

This is why the entire Consumer Price Index basket should be used. First, the target inflation measure should be representative, reflecting the real cost of living and consistent with people’s daily experiences.

Second, the representative basket needs to be updated more frequently, for example every three years, to reflect changing consumption preferences. For example, people are spending more on mobile services and eating out, which affects their food spending.

Third, we now have digital tools to capture near real-time movement of prices; This can be done by calculating a price index based on retail transactions recorded in the GST network. The data is anonymized and can be calculated separately for subcategories such as food, clothing and consumer durables. As the GST network expands, it will better represent the entire consumption basket and spending patterns.

Fourth, general price stability can be achieved and is consistent with large changes in relative prices. With inflation remaining stable, smartphone costs may decrease while healthcare costs may increase. This situation reflects the changing structure of the economy, although the general level of prices remains constant.

Stable inflation, along with changing relative prices, serves as an important signal by directing the flow of private investment to increase supply capacity towards sectors exhibiting higher demand and stronger relative prices. If there is high and volatile overall inflation, this signaling role is impaired, making it difficult for consumers and investors to make decisions.

It is not government spending that can help sustain growth in the medium and long term, but private investors and markets that stimulate growth through their decisions.

In India, it has been repeatedly shown that interest rates alone do not determine investment decisions; These decisions are influenced by the general investment environment, demand outlook and policy stability. The RBI has a long way to go before inflation stabilizes at the mandated level of 4%. Until then, a relatively tight monetary policy is justified.