Scepticism about inflation targeting: Edward Chancellor

Inflation targeting has become the norm in many countries, including India. Edward Chancellor, journalist, historian and author, sounds a sceptical note in this article. He has provided a more elaborate critique in a book, The Price of Time.

Chancellor says that inflation targeting has allowed central banks to set ultra-low interest rates in response to bouts of deflation and to justify the same by citing the inflation target given to them. As long as inflation stays below target, the interest rate set by a central bank is okay.

Chancellor thinks that is not okay. There are a number of malign effects of ultra-low rates that must be taken into account:

Yet these targets produced a number of corruptions and distortions. Ultra-low interest rates pushed the US stock market to near record valuations and provided the impetus for the “everything bubble” in a wide variety of assets ranging from cryptocurrencies to vintage cars. Forced to “chase yield”, investors assumed more risk. The fall in long-term rates hurt savings and triggered a massive increase in pension deficits. Easy money kept zombie businesses afloat and swamped Silicon Valley with blind capital. Companies and governments availed themselves of cheap credit to take on more debt.

Central banks must, therefore, be guided not just by the level of inflation but also by its effects of interest rates on asset valuation, financial stability, leverage and investment. In other words, we are back to multiple objectives for central banks instead of a single objective, namely, inflation! 

This may sound plausible. Except that, elsewhere, Chancellor argues that the alternative to ultra-low interest rates is simply to not respond to bouts of depression because they tend to cleanse the economy of unproductive or inefficient firms. That is more than a little extreme. The idea that governments should have stood by when the pandemic erupted is hard to swallow. You must read Martin Wolf's critique of Chancellor's  book to get the complete picture. It is all very well to ask central banks to take asset bubbles into account but we know that that is a notoriously difficult task. When is an increase in asset values a bubble? We do not have a clear answer. 

At the same time, as Wolf points out, it is important to take on board Chancellor's plea to factor financial stability into central bank policy. The interest rate is a useful tool for battling recession. At the same time, central banks must address threats to financial stability through various instruments of regulation. Excessive leverage is an issue both in the financial sector and in the corporate world. Wolf says that removing tax deductibility for debt must be part of the solution. The solution has been urged by many. The time may have come to consider it seriously.

Inflation in India: potential breach of MPC mandate

There is much breast-beating over the possible breach of the upper limit for inflation of 6 per cent set for the MPC. The RBI has come in for flak from some quarters.

The critics make no allowance for the fact that the challenges facing the world economy are unprecedented. To be doctrinaire in one's approach in such a situation is not helpful.

The inflation rate for the current year is projected at 6.7 per cent (without factoring in steps the RBI would take to contain it). The RBI's approach, reflected in the views of its three members on the MPC, is to bring inflation to within the tolerance band without too much of a sacrifice of growth. I cannot see how this approach can be faulted.

The Indian economy's growth rate sank to 3.7 per cent in 2019-20. Thereafter, in 2020-21 it declined by 6.6 per cent.  It recovered to 8.7 per cent in 2021-22. Real GDP in 2021-22 was just 1.5 per cent above the level in the pre-pandemic year of 2019-20. Under the circumstances, it is impossible for the RBI to ignore the growth imperative. 

Some argue that growth is not part of the mandate of the MPC. Well, it is part of the mandate of the RBI. Are the three RBI representatives on the MPC required to be blind to considerations of growth when they sit on the MPC? The MPC works within the framework of RBI just as RBI, while autonomous, works within the framework of government.

To those who say that the MPC mandate is sacrosanct, I would say: it is certainly not part of the mandate to kill the Indian economy!  

For a vigorous defence of the RBI's approach, you may read Michael Patra's address of June 22.

I have commented on the issue in my last column in BS. As the article is behind a pay wall, I reproduce it below.

FINGER ON THE PULSE

T T RAM MOHAN

Negotiating India’s soft landing  

The glass is half-full. Inflation at the moment may be above the upper limit of the inflation targeting framework but there is room for optimism about growth prospects for the Indian economy in 2022-23.

The inflation rate needs to fall. But analysts seem to be having second thoughts about the degree of monetary tightening that needs to happen. That is the cause for optimism about growth.

The CPI inflation rate touched 7.9 per cent in April followed by 7 per cent in May. In June 2022, the MPC raised its inflation forecast for 2022-23 to 6.7 per cent. There was panic amongst market analysts. Some analysts saw the repo rate going up to as much as 6.25 percent in 2022-23 over the starting point of 4 per cent.

There seems to have been a rethink since. RBI Deputy Governor Michael Patra’s well-argued address on June 22 to the PhD Chamber of Commerce and Industry has had a sobering effect on the markets. After the address, the yield on the ten-year government bond fell by 18 basis points. That says something about the credibility of RBI’s pronouncements on monetary policy.

Mr Patra made three important points. First, he indicated that we might expect inflation to fall back into the tolerance band of 2-6 per cent by the fourth quarter of 2022-23. Secondly, Mr Patra seemed hopeful that “monetary policy actions in India will be more moderate than elsewhere in the world”.

The third point is potentially more controversial. Mr Patra indicated that inflation may exceed 6 per cent for three successive quarters, which would be a breach of the MPC’s mandate. However, if India’s GDP can grow at 6-7 per cent in this year and the next, “the RBI will have fulfilled its mandate of prioritising price stability while being mindful of growth.”

Read together, the second and third points could be interpreted to mean that interest rate hikes hereafter would not be so drastic as to cause GDP growth to fall below 6 per cent. This approach may result in a breach in the accountability mandate of the Monetary Policy Committee (MPC). So be it, Mr Patra seemed to suggest.

Some are outraged. How could the MPC countenance such a breach? Mr Patra has a plausible response: these are “extraordinary times”. Nobody can disagree. Having just emerged from successive waves of the pandemic, the world economy is facing new supply constraints. The last thing we need now is that, in reining in demand, we create supply constraints within the Indian economy as well. The critical issue in managing inflation is not so much the precise level of inflation as the predictability of it. The RBI must not give guidance that misleads the market. That is clearly not the case here.

So far, so smooth. The spoiler could be the actions of the US Federal Reserve. The Fed has of late taken a ‘we will do whatever it takes’ approach to fighting inflation. Market analysts feel the Fed could hike interest rates by a further 120-150 basis points in the months ahead. If the RBI were to match that, the repo rate could rise to as much as 6.4 per cent. That would render a soft landing difficult for the Indian economy.

The best outcome would be that the Fed does not hike the policy rate as much as feared. The other possibility is that the RBI does not have to match the Fed’s rate hikes. The price to be paid is a further flight of portfolio funds and a depreciation in the rupee.  We can live with such a depreciation. Despite the fall in the exchange rate of the rupee with respect to the dollar, the 40-currency real effective exchange of the rupee has remained virtually unchanged in May 2022 compared to May 2021.

Mr Patra is right. When it comes to a soft landing, India is better placed than the US and many European economies. Even at May’s inflation rate of 7 per cent, inflation in India is 2.5 percentage points above the average for the previous five years. In the US, the difference is about 5.5 percentage points. Monetary tightening required is greater in the US.

Secondly, as the latest annual report of the Bank of International Settlements notes, the Phillips curve, which gives the trade-off between inflation and unemployment, has turned flat in the US in recent years. The flatter the Phillips curve, the greater is the monetary tightening required to produce a given fall in the inflation rate. In India, the Phillips curve seems to have acquired its normal shape after having been relatively flat for six years starting 2014. (RBI Bulletin, November 2021).

Mr Patra’s address, which echoed many points the RBI Governor had made earlier, may prove to have been a turning point in shaping the inflation trajectory in the months ahead.

Banking sector in good shape

The health of the banking sector is yet another cause for optimism about the economic outlook. The latest Financial Stability Report of RBI points to several indicators of improvement.

Gross Non-Performing Assets (GNPAs) were at a six-year low of 5.9 per cent of advances in March 2022. They are expected to fall further to 5.2 per cent in March 2023. Capital adequacy in the banking system averages 16.7 per cent, a full 5.2 percentages points above the regulatory minimum.  Provision coverage ratio is at a healthy 71 per cent. Annual credit growth in June 2022 was 13.1 per cent, a rate last recorded in March 2019. India’s banking system can be said to have emerged from a banking crisis that lasted nearly a decade.

If the projected NPA level is correct, regulatory forbearance during Covid has paid off. It hasn’t ended up postponing the day of reckoning, as critics had feared.  

Unless the geopolitical situation worsens considerably, the Indian economy should manage growth of 6.5-7 per cent in 2022-23 while inflation falls gradually to within the tolerance band. In today’s troubled environment, that would be a considerable achievement. It would show that the Indian economy is stronger today than in earlier crises and we are getting better at macro-economic management.

Roe v Wade: the economics of abortion

Martin Sandbu, writing in FT, argues that the recent US Supreme Court judgement overlooks the economic implications of abortion and the judgement is flawed for that reason. (Please see my earlier post below first).

In his judgement, Justice Alito said that a balance has to be struck between the "interests of a woman who wants an abortion" and the individual states'  "interest in protecting fetal life". It was for individual states to determine where that balance lay.

Sandbu argues that not granting abortion in the interest of protecting fetal life has serious economic implications for the women involved. He cites a study that has shown that women denied abortion are more likely to end up in poverty than those who were not. There are other studies that have shown that women who had the right to abortion had a better chance of finishing college and getting a professional occupation.

The right to abortion not only has implications for poverty and inequality in society, it also influences the equations between the sexes. Besides, Sandbu argues, those who profess concern for fetal life have not shown much interest in providing the necessary economic support to those denied abortion and who are compelled to raise children in trying circumstances. The anti-abortionists often are also against welfarist measures.

These are all valid and fairly incontrovertible points. But how does change the fundamental proposition put forward by the US Supreme Court? Faced with all the above facts, it is legislatures that have to make choices and they have to make those choices based on their understanding of the will of the people. If people in a given state believe that denying abortion results in an incorrect balance between individual and societal interests, they are free to give expression to their will through the power of the ballot.

I'm afraid the point I made in my earlier post on the subject does not change: the Supreme Court ruling is about what the Constitution says, it is not about taking a position on abortion

Roe V Wade: it's about interpreting the US Constitution

There has been outrage over the judgement of the US Supreme Court overturning the historic judgement in Roe V Wade that affirmed women's right to abortion. 

A commonly heard observation is that right-wingers, who hate abortion, have been planted in the Supreme Court by Republican administrations and they have had their way.

One needs to be clear about what the US Supreme Court has said. The Court does not say that abortion is bad and should be outlawed. No, it says that the US Constitution does not include the right to abortion. So, if people want the right to abortion, it is up to individual states to make legislation that reflects the will of the people. 

The SC is interpreting the Constitution as it understands the document. It is not taking a position on abortion. If the people of the US want an overarching legislation that confers the right to abortion across states, it is is up to Congress to make suitable amendments to the US Constitution. I'm afraid many of the harsh comments on the judgement seem to overlook these points.

FT has provided excerpts from the judgement that make the above points crystal clear. Here is a quote from the majority judgement written by Justice Samuel Alito:

We hold that Roe and Casey (another ruling on the abortion question) must be overruled. The constitution makes no reference to abortion, and no such right is implicitly protected by any constitutional provision, including the one on which the defenders of Roe and Casey now chiefly rely — the Due Process Clause of the Fourteenth Amendment. That provision has been held to guarantee some rights that are not mentioned in the constitution, but any such right must be “deeply rooted in this nation’s history and tradition” and “implicit in the concept of ordered liberty”.

A concurring judgement by Justice Cavanagh provides the clarification I mention above:

 To be clear, then, the court’s decision today does not outlaw abortion throughout the United States. On the contrary, the court’s decision properly leaves the question of abortion for the people and their elected representatives in the democratic process.  ..... In sum, the constitution is neutral on the issue of abortion and allows the people and their elected representatives to address the issue through the democratic process. In my respectful view, the court in Roe therefore erred by taking sides on the issue of abortion.