Inflation targeting and the Indian economy

In March 2015, Reserve Bank of India (RBI) officially adopted inflation targeting as the monetary policy framework for the Indian economy. Naturally the question arises that what is inflation targeting and why did India adopt inflation targeting.

Inflation targeting basically means bringing the inflation to a targeted level within a specific time horizon. To answer the second question, we must get into the history of inflation in the Indian economy.

A close look at the Indian experience with inflation will show that India has always had a perpetually high level of inflation at around 12% (Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework, 2014), be it the Wholesale Price Index (WPI) inflation which is a barometer of the cost that the Indian Inc incurs or the Consumer Price Index (CPI) inflation which shows the cost that the consumer incurs. Increase in cost, whether it is for the producers or consumers never bodes well for the economy neither for the political overlords who have a lot to lose if cost in the economy is persistently increasing. It also causes tax distortions and disruptions in the price discovery mechanism in the economy. The belief was that adopting the monetary policy strategy of inflation targeting would help the RBI in bringing down inflation as well as give the central bank independence from the meddling of the government which would ultimately lend credibility in the market to the policy stance taken by the RBI.

With the definition and motivation of inflation targeting out of the way, let’s now focus on the structure of the Indian economy and what it entails for adopting an inflation targeting framework. The Indian economy has several structural features which does not bode well for an inflation targeting framework. Specifically, the supply side bottleneck of the agricultural sector which depends on the whims of the monsoon. If there is a poor monsoon, prices of food items increase.

Another structural feature unique to the Indian economy is the wage price spiral. India is an economy where 93% (Economic Survey of 2018-19) of the employment is generated in the informal manufacturing sector with labourers receiving daily wages.

Food being a necessary item forms a major portion of their wage income, hence leading to the fact that any increase in prices of food items will result in the workers bargaining for an increase in wage to protect their buying power. Inflation targeting controls the inflation level by increasing or decreasing the interest rate prevailing in the economy. RBI does it by increasing or decreasing the repo rate in the economy. Increase in interest rate is believed to bring down the inflation level in the economy by curtailing the amount of economic activity whereas decreasing the interest rate increases the inflation level of the economy by increasing the economic activity. Increase or decrease in the interest rate does not address the structural issues as we have discussed.

Our paper focuses exactly on these structural features and how inflation targeting may fail to address these issues. We build a model incorporating the structural features of the Indian economy in a growth theoretic framework. A well-documented feature of economic growth across countries is the associated changes in the composition of sectoral output, employment, and consumption structure known as 'structural change'. Two of the stylised facts of structural change are the following:

(i) Falling expenditure share of goods (against services),

(ii) Falling relative price of goods compared to services.

These facts suggest that as per capita income rises, expenditure shares and relative price turn towards income and price elastic goods. Are the facts (i) and (ii) mutually independent or related? Stated differently, is there a link between structural change and relative price movements in an economy? If such a link exists, it may offer insights into ‘inflation targeting’ in developing economies.

In our paper we show that changes in relative price and structural change are an outcome of how imbalances in the sectoral growth rates driven by the structural features of a developing economy are corrected over time. The closing of growth gap is accompanied by continuous changes in the market clearing relative price, leading to changes in output composition, and in turn giving rise to structural change. The dynamics of the relative price over time is a characteristic of the complete growth path of the economy.

The policy implication of this paper goes much beyond; inflation targeting has become the norm of monetary policy throughout the world but developing economies unlike developed economies are going through a phase wherein structural change seems to be a persistent phenomenon. In developing economies, the agricultural sector has a large share, and the model shows how such initial imbalance gives rise to an eventual increase in the relative price of agriculture and accompanying structural change. Since price change is a property of long-run growth, the study of inflation must go beyond the usual short-run analysis of output-inflation trade-off.

The short-run policy must, therefore, be consistent growth path of the real sectors, driven by the underlying economic structure. Our finding is that the dynamics of the real sector play a paramount role in changes in relative price and thus in structural change. Policies that attempt to rectify sectoral imbalances are as important as monetary policies that tackle inflation in the developing economies. Although inflation targeting is a relevant policy weapon, for developing economies it needs to be taken with a pinch of salt. The policy decision that can be concluded is that it's the slowest growing sector that determines the growth of an economy and to increase growth and decrease inflation, one needs to focus investment in the slowest growing sector (agricultural sector).

(The study has been authored by Sudipta Sen)