Should RBI target inflation? Lars Hansen's comments prove Raghuram Rajan right

In recent days, two Nobel laureates have come with contrasting views on what should be the primary concern of Indian economy and the Indian central bank–growth or inflation. This age old question also has a significance in the recent context. This is one of the reasons ultimately contributed to the decision of outgoing Reserve Bank of India (RBI) governor, Raghuram Rajan, for not taking up a second term at Mint Road.

Rajan’s unflinching focus on inflation target and his reluctance to cut interest rates sharply as desired by the growth-lobby in the course of the three-year long inflation battle are among the reasons that forced Rajan to have a serious face off with the Narendra Modi-government.

But Rajan has found a supporter in 2013 economics Nobel Prize winner, Lars Peter Hansen, who is also the David Rockefeller distinguished service professor of economics at Chicago University. Hansen said the RBI should continue with its inflation focus in an interaction with the Press in Mumbai. “The central bank should, as it has been doing so far, continue to focus on inflation. I think much too often people expect the central bank to do too much,” said Hansen.

Since he took over as RBI governor in 2013 September, Rajan has kept interest rates high to fight inflation but began cutting rates from January 2015. Since then, the RBI has slashed rates by a total of 150 basis points. The retail inflation, which was in near-double digit levels in 2013, has come down to 5-6 percent now, but has been inching up in recent months at a sniffing distance of the central bank’s upper target of 6 percent.

Rajan had highlighted the spike in inflation as a reason to justify the course of his cautious rate easing approach in the past. It was under Rajan’s leadership at RBI, the central bank moved into a CPI-inflation targeting mechanism. The RBI is currently in discussion with the government to finalise the structure of new Joint Monetary Policy committee (JPC) as per which the RBI will be given an inflation target.

But, Joseph Stiglitz, American economist and Nobel laureate, had questioned the RBI’s excessive focus on inflation saying the country should focus on “rapid rate economic growth” and not get “overly obsessed with inflation,” which can then turn into greater problems like joblessness. “There are two aspects relevant for India (at this juncture). The first is making sure that the overall economy grows at a rapid rate, and that means not being overly obsessed with inflation. Extensive focus on inflation almost inevitably leads to higher unemployment levels and lowered growth, and therefore more inequality.”

In fact, Stiglitz isn’t the only one who has argued against the central bank’s excessive inflation focus strategy. Even former RBI governor D Subbarao wasn’t a big fan of inflation targeting. In his tenure, Subbarao had cited a few reasons why India shouldn’t be an inflation targeting country. Of those reasons cited by Subbarao, at least two are relevant even today. They are:

First, “The drivers of inflation in India often emanate from the supply side, which are normally beyond the pale of monetary policy. In particular, given the low income levels, food items have a relatively larger weight in the consumption basket in India compared to advanced economies and even many emerging market economies. Monetary Policy, as is well known, is an ineffective instrument for reining in inflation emanating from supply pressures.”

Second, ‘In an emerging economy like ours, it is not practical for the central bank to focus exclusively on inflation oblivious of the larger development context. The Reserve Bank cannot escape from the difficult challenge of weighing the growth-inflation trade off in determining its monetary policy stance.”

Besides these two, Subbarao also cited an inefficient monetary transmission mechanism as a negative for passing monetary policy signals to the banking system. But, this problem has been largely addressed with the central bank pushing banks to follow marginal cost of funds method to adjust their lending rates. But Subbarao’s caution that it will be difficult for the RBI to deliver on strict inflation target, partly because as much as 50 percent of inflation is beyond the control of monetary policy, is still warranted today.

The debate on inflation-targeting is even more relevant today because high prices have made life difficult for India’s poor, especially when it comes to prices of essential commodities and services. To meet this challenge, there has not been a corresponding increase in the rural income, various studies estimate. From a layman’s perspective, inflation continues to be a big worry rather than GDP growth that hasn’t really translated into job creation.

Rajan himself countered questions on his excessive focus on inflation and not growth with his following response. “When people say inflation is low, you can now turn to stimulating growth”, they really do not understand that these are two sides of the same coin. The RBI always sets the policy rate as low as it can, consistent with meeting its inflation objective,” Rajan had said.

But, the bottom line is when inflation is riding so high and snatching away the fruits of so-called high growth from the rural households, the GDP growth figures do not mean much to the poor. Inflation continues to be the primary concern. But the worrying part is that the RBI has only limited tools to check a supply-side driven inflation. The job is mainly that of government.