Flexible inflation targeting: Here's what Rajan needs to do

The new government wants the economy to recover at the earliest. The linkage of fiscal deficit with unproductive aggregate demand expansion which fuels inflationary expectations is now well understood, notes Siddhartha Roy

The bi-monthly monetary policy will be announced on Tuesday.

Public statements made by Reserve Bank of India policymakers tend to suggest that Consumer Price Index-based anchor inflation rate has not come down sufficiently to merit a reduction in policy rates. 

On the other hand, anyone looking forward to an equated monthly instalment-based loan or running an industrial unit, particularly from the MSME sector, is getting increasingly restless about this status quo proposition.

For them, an interest rate reduction is an immediate necessity.

To add to an already complicated situation, in its September 20-21, 2014 Cairns meeting, the International Monetary Fund came up with the suggestion that India should increase policy rates for sustainably lowering inflation. 

In behavioural economics, this is called “decoy effect”, it will ensure that even a status quo proposition from RBI looks significantly superior.

Should one examine the inflation numbers, they are quite revealing.

CPI-based inflation on a (year-on-year) basis has come down from 8.59 per cent in April 2014 to 7.80 per cent in August 2014; without taking food and fuel inflation into account, the non-volatile part that is the core CPI-based inflation has come down from 7.92 per cent to 6.83 per cent.

Wholesale Price Index-based inflation for the same period has come down from 5.5 per cent (April 2014) to 3.74 per cent (August 2014); lastly, while CPI food inflation continues to be sticky at 9 per cent plus level, WPI-based food inflation has come down to 5.2 per cent in August. 

Release of food stocks and management of imports of the shortage items are having their impact.  

At the same time, between May and July the Index of Industrial Production growth rates have steadily come down and manufacturing growth became marginally negative in July.

The new government wants the economy to recover at the earliest.

The linkage of fiscal deficit with unproductive aggregate demand expansion which fuels inflationary expectations is now well understood.

The current Budget has a road map for bringing it down.

Similarly, regulatory bottlenecks which create supply side constraints and push the cost base of existing enterprises and new investments upwards are getting addressed.

Empirical studies show the key drivers of CPI are agricultural output (lighter agri-output has a negative impact on inflation), fuel price (has a positive impact on inflation), exchange rates (depreciation adds to inflation), money supply (M3) and previous period’s CPI, the last two have a positive impact.

RBI’s ability to influence majority of these variables is limited excepting money supply.  

Consequently, it is not clear how RBI will achieve a 6 per cent inflation rate by January 2016 without creating unacceptable deflationary pressures, this will not only make the industrial sector vulnerable but will also add to the banking sector’s stressed assets. 

It would be better to stretch the time span for reaching the inflation target and thereby protect the nascent economic recovery.    

In other words, reconciling inflation targeting with the economic and industrial growth requirements in a decelerating policy rate regime would provide the platform for the success of RBI’s medium-term policies.

Image: A hawker arranges mangoes at a roadside shop in Chennai. Photographs: Babu/Reuters

Siddartha Roy is economic advisor, Tata group