Setting a Course for India’s Inflation Nirvana; The RBI’s New Inflation Target Could Mean Higher Rates for Longer
January 24, 2014 Leave a comment
Raghuram Rajan’s project of fixing India’s dilapidated central bank now has a plan. Sticking to it could prove tumultuous for investors.
In a report out Tuesday, a committee of top Reserve Bank of India officials and outside economists appointed by central bank chief Mr. Rajan made some notable recommendations, especially establishing a target for consumer-price inflation. This is likely what Mr. Rajan wanted to hear. He made similar recommendations when he chaired such a committee five years ago as a private citizen. This time, he has the power to implement them.
Going after consumer prices makes sense: Over the past five years retail inflation has rarely come below 8%, despite sickly growth. Such unstable prices are a big reason foreign investors abandoned India during the “taper” scare last year.
It’s encouraging that the committee specified headline inflation, rather than core inflation, given that as a poor country, India has a consumer basket that’s about 60% food and fuel. The RBI previously targeted “multiple indicators”—a jumble of inflation, growth, financial stability and exchange rates that confused investors about the bank’s intentions.
If Mr. Rajan adopts the new target, investors should gird for higher rates. As it stands, RBI’s policy rate is more than two percentage points below inflation. The inflation target would start at 8% in the first year, then drop to 6% and eventually to a range of 2% to 6%. Considering how stubborn Indian inflation has been, one could imagine the need to raise rates aggressively to stick to the target.
There are problems. One is the RBI’s ability to forecast what it’s targeting. The central bank’s inflation outlook often misses reality by wide margins. Consumer prices are particularly hard to forecast because of volatile food and fuel, says Vidya Mahambare, an economist at credit rater Crisil.
Politics is a bigger impediment, especially things outside of the RBI’s control. The committee recommended the government keep fiscal deficits below 3% of GDP and stop artificially boosting wages to prevent money sloshing around the economy. Sounds great, but that’s up to politicians in New Delhi, not Mr. Rajan.
That Mr. Rajan looks set to give India a new focus on inflation is undoubtedly a good thing. Hitting the target will be much harder.
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