Friday, March 14, 2014

Urjit Patel report on monetary policy

There has been a fair bit of controversy over the Urjit Patel committee report on monetary policy. The idea of inflation targeting, in particular, has drawn flat. DM Nachane, member PM's council of economic advisors, has a very good critique in EPW.

First, Nachane questions the assumption that there is no long-run trade-off between inflation and output, which is another way of saying that the Phillips curve holds only for the short-run. This, he says, has been "empirically rejected" in recent research.

More importantly, he believes that inflation targeting won't work for the following reasons:

i. It means letting go the nominal exchange rate- and that's hard to do, given the havoc that can be wrought by sharp movements in the exchange rate. (eg if the exchange rate is appreciating, you may need to lower the interest rate but you can't do that if inflation is above your target).

ii. It's hard to practise as long as the fisc is out of control.

iii. Inflation targeting does not mean asset price stability and hence financial stability- this is the great lesson from the sub-prime crisis.

One might add a point that has been made by others in the debate: when inflation is largely supply-driven and, that too, food-driven, targeting it through demand side policies will cripple growth without making a dent on inflation. The really solid case for inflation to be kept within a limit would be that otherwise we could have prolonged currency depreciation and this would undermine confidence of foreign investors. But it is not necessary that the currency should depreciate if there is an improvement in productivity. 

Nachane also makes weighty arguments against the use of the CPI instead of the WPI for measuring inflation. One is that the CPI is more representative of the consumption of the better off because consumption is weighted by each household's expenditure- what he calls a 'plutocratic bias'.

Incidentally, the problems with inflation targeting don't go away if parliament sets the inflation target, a solution that has been mentioned in the debate. Inflation targeting is not desirable in the present Indian context. Period.

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