January 26, 2014 8:03 pm
Six months after his appointment as governor of the Reserve Bank of India, Raghuram Rajan has already left his mark. The former University of Chicago academic has shown that he is serious about reining in India’s rampant inflation – among the highest in the Group of 20 leading economies – raising interest rates twice in the autumn. Local businessmen complained, saying that tighter money would damage growth. But Mr Rajan’s decisive move has won him plaudits from foreign investors, helping the rupee climb back from the depths of the summer.
India’s currency is now back on a rollercoaster, after emerging markets were hit by a heavy sell-off last week. The rupee fell 1.8 per cent against the dollar to Rs62.7, the biggest five-day drop since the end of August. True, India was less affected by the upheaval than other low and middle-income countries, such as Argentina. But the turmoil shows that Mr Rajan’s fight is not over.
Whatever happens, however, the governor has a card up his sleeve. Last week a committee that he appointed recommended that the central bank change the framework it uses to set monetary policy, adopting a formal inflation target. For the past two decades the RBI has adjusted the money supply on the basis of a range of variables, including capital flows and the exchange rate. The adoption of inflation targeting would bring India in line with most advanced economies as well as several emerging markets.
Inflation is a significant drag on the Indian economy – and not just because it gives jitters to investors. Since prices are growing faster than in other countries, it is harder for Indian businesses to sell their goods and services abroad. Fast-rising prices tend to be more volatile, making companies warier of investing in new projects. An economy marred by high inflation is also more unequal: since the poor tend to hold a larger proportion of their savings in cash, they are the worst hit by accelerating prices.
In these circumstances, inflation targeting can be extremely handy. One of the reasons why it is hard to bring down high inflation is that workers continue to demand big pay rises as they expect prices to keep growing quickly in the future. A central bank that commits to target a given rate of inflation can change expectations, helping to break this vicious circle. Indeed, countries that implemented inflation targeting in the 1990s enjoyed lower inflation rates than would have been the case had they not adopted this framework.
There are potential problems with an inflation target in an emerging economy such as India. More than in advanced economies, the consumer price index (which the RBI wants to target) is dominated by subsistence goods, such as energy or food. These items are subject to external shocks, which may force the central bank to react even when interest rates can do little to solve the underlying causes of inflation. This is why the RBI is right to be thinking about targeting a band, rather than a single-digit benchmark. This flexibility would be handy even in the event of temporary currency shocks.
Changing the monetary framework will not, on its own, solve India’s inflation problem. This requires building better infrastructure so that food and other goods are transported more easily, limiting the risk of price spikes. It is also necessary that the government narrows its large budget deficit, for example cutting rural employment programmes that help to push up wages artificially in the countryside. Still, these are not good reasons for the RBI to renounce an inflation target. Provided the central bank shows it is committed to meeting the new benchmark, this could be Mr Rajan’s long-lasting legacy in the battle against inflation.
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