The RBI targets an inflation rate of 4%. In this article, Gurbachan Singh takes an in-depth look at the prevailing macroeconomic policy regime. This exercise provides an insight, which forms the basis for an alternative policy regime under which it is makes sense to target a lower inflation rate.
The Reserve Bank of India (RBI) has adopted the policy regime of inflation targeting; it targets 4% inflation rate (RBI, 2014). Why does the RBI target inflation of 4%? To understand this, let us look at the US experience first.
Lessons from US for India: Right and wrong
Although it is not openly accepted, the US Federal Reserve (Fed) has had a target of 2% inflation rate for a while. The reason why it is a positive rate is that there can be wage-price rigidities in the economy that may be overcome by maintaining some inflation1. It is assessed that 2% inflation will do. This also gives the central bank room to reduce its nominal interest rate in a recession. To see this, assume that the real interest rate is 1.5% in normal times. Then the nominal interest rate in normal times would be 3.5%. So, in this example, in a recession, the Fed can reduce the nominal interest rate by 3.5 percentage points before it hits the zero lower bound (ZLB). In practice, after the Great Recession began around the year 2007 in the US, the Fed was constrained quite soon as it hit the ZLB. An important lesson from this experience is that it helps to have inflation rate higher than 2%. One suggestion was a target of 4% for the US (Blanchard 2010).
In this context, it appears that the RBI is better placed than the Fed has been. Indeed, the RBI chose the target of 4% inflation in the aftermath of the US experience; it may have been influenced by that experience though there can be other reasons as well2. While the 4% inflation target can be useful in India, it can hurt the public in general - and the less well-informed in particular – on an ongoing basis.
In this context, in determining the inflation target, it appears that there is a trade-off between overcoming the ZLB problem if and when it arises, and improving welfare in (relatively) normal times. This is indeed true, under the prevailing policy regime. However, this is not, as we will see, the case under a different policy regime (Singh 2014, 2015). Before we come to this, let us take a close look at the prevailing policy regime.
Prevailing policy regime
Assume, for simplicity, only households save and only firms invest. When the RBI lowers the interest rate in a recession it reduces the interest income of households. Also, it reduces the interest cost incurred on funds borrowed by firms for the purpose of real investment. The low interest rate policy is effectively a policy of an implicit tax on households and an implicit subsidy for firms. So, there is redistribution from households to firms at a time when unemployment may be high.
Next, consider a boom; the conventional policy in this case is to increase the interest rate. This acts as an implicit subsidy for saving households and as an implicit tax on investing firms in a boom. This acts as redistribution from firms to households in a boom but does not negate3 the opposite redistribution in a recession.
Observe that the prevailing monetary policy over the macroeconomic cycle is actually implicitly a countercyclical fiscal policy; it is also a redistributive policy.
While the prevailing policy can be used in a boom, the same is not always true in a recession. This is because the RBI is supposed to keep reducing the interest rate till recovery from a recession is in sight but it cannot reduce it below zero.
Proposed policy regime: A paradigm shift
Consider an explicit tax-subsidy scheme by the Government of India (GoI). In a recession, it is proposed that the GoI should give an explicit subsidy to firms on the interest cost incurred on real investment. In a boom, the GOI should impose an explicit tax on firms on the interest cost on real investment. The purpose is to encourage (discourage) real investment in a recession (boom). Given that there is both an explicit subsidy in a recession and an explicit tax in a boom, there is intertemporal balance in GoI’s budget (for macroeconomic stabilisation).
The proposed policy regime is obviously a case of explicit countercyclical fiscal policy. It is interesting that in this scheme there is no redistribution from households to firms.
The proposed policy does not include any new subsidy beyond what is already prevailing; it is just a quest for shifting from an implicit subsidy to an explicit subsidy; this makes it not just more transparent but also more useful. Furthermore, the subsidy is not on the entire real investment; it is on the interest cost incurred on borrowed funds that are used for such investment. So the subsidy is not on the component of real investment that is financed by, say, retained earnings of firms. In any case, the proposed policy is not just about a subsidy scheme. It is about a subsidy in a recession and a tax in a boom.
It is true that the proposed policy regime involves more administrative work; the prevailing policy regime is much simpler. However, the simplicity of the traditional monetary policy (the implicit tax-subsidy scheme) comes at a huge economic cost. It affects interest rate for both real and financial investments. In contrast, the proposed tax-subsidy scheme is well targeted as it is specifically for real investment alone4. In any case, the administrative difficulties should not get exaggerated because in these days of computerised accounting and calculations of relevant taxes and subsidies, it is primarily a matter of rewriting of the required software.
Though political forces determine the usual tax policies in the domain of public economics, there can be a constitutional provision that enables an independent authority to manage the proposed explicit tax-subsidy scheme for macroeconomic stabilisation.
It is true that there can be some misuse of the explicit subsidy under the proposed policy regime. However, the situation can be worse under the prevailing policy regime. This is because the use of the implicit subsidy under the prevailing policy regime is legal and even legitimate for any purpose. Thanks to the non-transparent nature of the implicit subsidy under the prevailing policy regime, it is very unlikely that auditors and even macroeconomists would even raise the question of, what can get viewed under an alternative policy regime as, possible misuse of the subsidy.
The target inflation rate
Recall that the traditional monetary policy (implicit subsidy scheme) cannot be used once the interest rate hits the ZLB. It is, however, interesting that an explicit subsidy on interest cost on investment by firms can be used in a recession regardless of the level of the interest rate. So, even if the nominal interest rate is zero, the GoI can always pay out a subsidy to bring about a further effective reduction in the interest rate! Given that the GoI can take care of the effective reduction in interest rate for investing firms in a recession, the RBI need not worry about whether or not it can reduce its nominal interest rate adequately. It follows that the nominal interest rate need not be high in normal times to begin with. Accordingly, the inflation rate targeted by the RBI need not be high in normal times, given the paradigm shift in macroeconomic policy suggested here.
The present inflation target in India is 4%. In the light of the above analysis, it can be reduced. Should the new target rate of inflation be 3% or 2% or even 1%? This can be debated but the point of this article is to suggest that there is scope for a reduction. This line of research is not about precise answers but it is about exploring alternatives meaningfully (Caballero 2010).
- Consider an example of conventional wisdom on this aspect. If the money wage has downward rigidity but there is a need for a lower real wage for reducing unemployment, then it helps to have inflation. This reduces real wage for a given money wage.
- It is true that fluctuations in the prices of food and oil matter more in an emerging economy than in a developed economy. However, trade (and flexible tariff) policy, domestic fiscal policy, the public distribution system, and possibly even the public sector oil firms can be used to stabilise these prices. To the extent that there is still fluctuation, this is more an argument for greater flexibility around the targeted inflation rate rather than for a higher inflation target itself.
- This is because the household is in greater need of funds when there is unemployment in a recession (and also borrowing is difficult) than in times of a boom.
- The prevailing interest rate policy of the RBI can induce asset price volatility; asset prices can be more stable under the proposed policy. For more on this, see Singh (2015).
- Blanchard, Olivier, Giovanni Delláriccia, and Paolo Mauro (2010), “Rethinking macroeconomic policy”, Journal of Money, Credit and Banking, 42(1):199-215.
- Caballero, Ricardo J (2010), “Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome”, Journal of Economic Perspectives, 24(4):85-102. Available here.
- Reserve Bank of India (2014), ‘Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework’, Mumbai.
- Singh, Gurbachan (2014), “Overcoming Zero Lower Bound on Interest Rate without any inflation or inflationary expectations”, South Asian Journal of Macroeconomics and Public Finance, 3(1):1-38. Available here.
- Singh, Gurbachan (2015), “Thinking afresh about central bank´s interest rate policy”, Journal of Financial Economic Policy, 7(3):221-232.