In today's Finshots, we talk about the problems with inflation targeting.


The Story

Inflation is bad. Nobody likes to see prices rise each day as they visit the neighbourhood Kirana store. So it’s imperative that the primary gatekeepers do their job. To this extent, the RBI adopts a very interesting approach to tame inflation.

The premise is simple. The central bank makes a projection to control the general rise in price levels and arrives at a figure that it deems acceptable. This is the “target” inflation rate and they attempt to steer the actual inflation towards this target.

They can do this by controlling the money supply. They can do this by adjusting interest rates. They can do this by leveraging multiple tools at their disposal. However, it’s extremely difficult to hit the bulls-eye each time. So they adopt a target range —say,  an inflation rate between 2–6%. And in an instant, the regime automatically evolves to a more flexible approach. This is the mandate RBI adopts.

However, with the lockdown in place, things haven’t been all that rosy. According to an article in the Print —

“The central bank is currently facing the grim prospect of answering to Parliament for failing to achieve its inflation target. According to the RBI Act, if average inflation stays out of the 2–6 per cent range for three consecutive quarters, then it is seen as a failure of the central bank. Average inflation was above 6 per cent in the March and June quarters, and also over 6 per cent in July and August.”

So how did this happen?

Well… Depending on who you ask, you’re going to get very different answers. But the most contrarian view is that inflation targeting simply does not work.

For instance, the principle thesis backing the regime is that when RBI sets its target, it anchors expectations. Not just at the central bank, but also, in government policy chambers, corporations, and bazaars. And so, if firms and consumers expect price levels to stay elevated, it could very well turn out to be a self-fulfilling prophecy. Workers will demand higher wages to compensate for the higher cost of living. Production costs will increase. Consumers might prepone purchase decisions and this might actually drive prices higher. However, if the expectations are reversed, it’s quite possible that we could tame inflation using the same logic.

But bear in mind, this is merely an intuitive prognosis. The actual realities might be very different. In fact, one recent study reveals that “In spite of 25 years of inflation targeting by the Reserve Bank of New Zealand, firm managers display little anchoring of such expectations.” And the authors conclude rather convincingly that inflation targeting does not anchor inflation expectations whatsoever.

The second argument is that even if we assumed inflation targeting does anchor expectations, the tools at RBI’s disposal are wholly inadequate to reign in price rise. The problem seems to stem from the index we choose to target inflation — CPI or the Consumer Price Index. For starters, the index represents a basket of goods and services that most ordinary folks consume on a daily basis. Which means the basket is heavily weighted towards food and fuel prices and small changes here can have a drastic impact on the final inflation figure. This is problematic because food and fuel prices dance to their own tunes. They depend on monsoons, on global crude oil prices, on government policy decisions and a whole host of other factors. So to presume that RBI can somehow tame these wild beasts is a bit rich, they say.

But there is another explanation that offers a very divergent view and it comes from an actual insider —Duvvuri Subbarao, former Governor of the RBI.

The governor once noted in his memoir that — “The Reserve Bank operates within the universe of knowledge available in real-time, and that universe is largely shaped by data. If the data are reliable and available in good time, policy response can be accurate and confident. But the Reserve Bank is oftentimes wrong-footed because of the questionable quality of data.” So its quite possible that the data might lead the central bank to do something under the presumption that inflation is well under control when in fact ground realities might be very different.

In fact, even if the target inflation rates were breached this quarter, the RBI can probably walk away without offering an explanation because inflation data for April and May was imputed. Meaning the surveyors could not actually collect the data and instead had to rely on estimations to arrive at the final figures.

So could data be the actual culprit?

What do you think?

Until next time…

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