By Sharvari Patwardhan and Shiva Reddy
Plummeting aggregate demand; a crumbling economy; kind efforts to curb the mayhem of unemployment. Is it time for monetary policy to set in? A naïve perspective would vehemently agree. However, the economic evolution of monetary policy has deemed it not simply a curative, but a preventive measure.
Cocoon of financial stability
Financial stability has been a growing concern, and monetary policy has received great attention as an important tool of cocooning a nation from economic instability. Monetary policy is concerned with managing liquidity and regulating the flow and quantum of money in an economy. Its objectives are multi-faceted. After deciding on certain goals, the central bank chooses a set of variables to aim for called intermediate targets, which have a direct effect on the goals. Since intermediate targets are not directly affected, certain operating targets are chosen which are more responsive to the plethora of policy tools available. The policy actions are transmitted through various channels.
Classical vs monetarist
There has been a long-drawn debate between the classical approach and the monetarist approach currently propagated. Keynes had a decided preference for fiscal stabilization measures. Demandthe primary factor driving output and growthmust be targeted efficiently. As interest-elasticity of investment is low, monetary policy would have a minimal effect on aggregate demand through the interest rate channel. Keynes advocated social security measures to affect the shorter-run credit cycle. However, this entails too much dependence on governmental administration.
Friedman supported a rules-based monetary policy that focussed on suppressing inflation by controlling money supply through an autonomous monetary authority. A downside of this theory is that the speculative demand for money cannot be controlled, failing to incentivize investment during a recession as growth prospects are low.
The discretionary policy gives the leeway to monetary authorities to act in accordance with their own judgement whereas rules impose restrictions on that judgement. Discretionary policy leads to policy uncertainty and faces of time-inconsistency. Rules resolve these convolutions. However, a completely rules-based policy makes the monetary framework very rigid. In a dynamic, globalised environment, rules fail to provide autonomy in decision-making. Thus, we must strike a balance between the two. In recent times, many central banks publicly announce certain monetary targets but maintain discretionary powers in executing them.
Effect of elections
Elections lead to policy uncertainty, not only for the Central Bank but also for the citizens. Pre-election, politicians manipulate fiscal policy spending. Shawn Cole (2007) states that more loans are dispatched to districts in which the ruling party had a narrow margin of victory (or a narrow loss) in the previous election. These loans are less likely to be repaid and temporary booms only spike inflation without lifting output. In India, election splurges typically increase M1 while productive output remains largely unaffected.
An emerging-market solution
In the recent times, various countries have adopted inflation targeting as their monetary policy regime. Starting with Chile in 1991, the number of emerging-market economies (23) adopting inflation target has outstripped that of advanced economies (9). Inflation is the nominal anchor and a range is announced within which inflation is to be contained, tying down expectations of economic agents. This also increases transparency of objects while holding the monetary authority accountable. Being a constraint on policy discretion, a nominal target resolves time inconsistency while maintaining autonomy.
Nonetheless, it is questionable whether inflation should be the sole focus of our monetary policy. Price stability does not necessarily ensure financial stability. The 2008 crisis has proved that inflation targeting alone is inadvisable and other monetary objectives must receive due attention.
Supply shock
The Reserve Bank of India’s (RBI) inflation target policy is shifted to rule-based with a transparent nominal anchor while maintaining operational autonomy. Headline Consumer Price Index (CPI) works as a nominal anchor to control inflation that gives the weight to different items. Food and fuel are given a total weight of 57.07 which is highly vulnerable to supply shocks in case of monsoon failure or rising international crude oil price. This could exceed the level of inflation bandwidth for a substantial amount of time, making it extremely difficult for RBI to control as was seen in the case of 2009 food supply shock.
According to Bernanke and Mishkin (1997), the inflation target is typically defined to exclude at least first round effects of supply shock such as changes in prices of food and energy. Regardless, the central bank should be completely autonomous and independent in achieving the long-run inflation target. Both of these prerequisites are missing in India’s case. Inflation target was diligently adopted to achieve price stability and moderate fluctuations in inflation in India.
With such a rules-based framework, the manner in which RBI tempers inflation is left to its discretion. Inflation target has proved to be a success in many countries, but will it stand the test of time?
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