‘India is not so distant from years of high and entrenched inflationary expectations that it should start trying to play games with the economy the way the West’s central bankers think they are entitled to,’ argues Mihir S Sharma.
Central banks, particularly in the West, are going through a profound shift in their mandates, responsibilities, and mechanisms — but one that is being pushed through without fully understanding the consequences, and without democratic discussion.
India can sometimes blindly follow the tides of policymaking fashion that emerge from the financial centre, under the illusion that as a mature economy it can make similar changes.
But India is a developing economy, with less stable institutions — and so it must be on guard against too hasty shifts in policy priorities, particularly when it comes to the Reserve Bank of India.
The most momentous such shift in recent times has come from the United States Federal Reserve.
During the annual Jackson Hole symposium of the world’s central bankers — held online this year, of course — the chairman of the Federal Reserve, Jay Powell, announced that the Federal Open Market Committee would alter its monetary policy strategy.
It would, in particular, shift to an ‘average inflation target’ of 2 per cent rather than an absolute target of 2 per cent.
This would, in effect, mean that the Fed has to tolerate — and perhaps even target — inflation higher than 2 per cent, as long as it could claim it was merely overshooting the 2 per cent mark to make up for lower inflation in the past.
This change followed a lengthy review of the Fed’s policy strategy, and the decision may in fact have been made before the Covid shock.
While apparently no more than common sense, this is in fact a major dilution of many aspects of what made inflation targeting so desirable for an independent central bank.
First, monetary targeting was considered important because it was transparent and predictable: It reduced chances that market participants would misunderstand what the central bankers were trying to do.
Once you knew their expectations of inflation, you understood their actions. Now it is less clear.
Second, monetary targeting reduced the discretion given to unaccountable technocrats in the central bank. They were given a legal mandate, and followed it.
Discretion has now increased: On what basis will the Fed determine the ‘average’ in ‘average inflation target’?
Powell said that following the period when the Fed achieved below-average inflation, policy will ‘likely aim to achieve inflation moderately above 2 per cent for some time’.
What does ‘some time’ mean? Are they targeting a specific price level? This is not just confusing, it is an expansion of the committee’s discretion.
Technocrats fail to understand that when they expand their own discretion they create the incentive for politicians to reduce their independence.
In this case, as the economist Ritha Khemani pointed out in a letter to the Financial Times, not making the period over which inflation is to be ‘averaged’ explicit might lead politicians ‘to manipulate this parameter to suit their own targets on interest rates’.
The Fed’s reasons for this shift are easy to understand. The relationship that they relied on between tight labour markets — when unemployment was at or below historic lows — and future inflation seemed to have broken down.
When labour markets are tight, according to much empirical evidence and theory, wages increase. These wage increases outrun productivity gains (linked to growth in goods and services) and inflationary pressures build up.
Traditionally, central banks would look at tight labour markets, understand that this is the likely consequence, and start tightening monetary policy in anticipation — which is precisely what the Fed did in the early years of the Donald Trump presidency, when the US labour market appeared to be overheating.
The problem is that inflationary pressures stubbornly refused to materialise.
Microeconomists and labour economists will probably understand this better than central bankers. Unions and collective bargaining no longer exist.
The gig economy has increased competition for employment and weakened wage growth.
Work and employment is itself different. People work from home, in multiple jobs; Uber drivers and Airbnb owners have even monetised their own household capital.
Demographic shifts have taken hold in major Western societies, and digitalisation means that productivity shifts and price changes are themselves harder to measure.
These are major structural shifts in markets, comparable to the deregulation of the 1980s, or even the growth of assembly lines in the 1920s. You can see that central banks feel the need to ‘do something’.
Hence the decision to essentially tolerate inflation above the target in the attempt to drive up employment.
But even if this impetus is understandable, that does not mean it is logical. It defies logic for a central bank to seek to maintain ‘maximum employment’ when we are largely unclear as to what ’employment’ even is in 2020.
It’s as if their ability to move markets has gone to their head, and now they think they can roll back the tide of technological and demographic change. Central bankers are suffering a collective case of egomania.
Indeed, the Fed’s actions may impact even the conservative European Central Bank (ECB). President Christine Lagarde said this month that she has restarted the ECB’s own strategy review in the wake of the Fed’s policy shift. The French nominee to the governing board and governor of the Bank of France, Francois Villeroy Galhau, explicitly suggested that the ECB shift to an approach similar to the Fed’s and judge inflation over the ‘medium term.
The Bank of England (BoE), meanwhile, is busy trying to pretend it is not monetising the UK’s deficit. Its governor has claimed that the deficit is only monetised by ‘a permanent expansion of the central bank balance sheet’ to support government spending; and yet there is no real sign that the BoE intends to offload its purchases of debt.
Their emerging world counterparts, including the Reserve Bank of India, might feel emboldened to follow in these central banks’S footsteps. It would be so easy — and cause the RBI to be popular in both South Block and on Dalal Street.
It would also be a mistake.
The Fed, the ECB and the BoE — not to mention the Bank of Japan — have at least some leeway to make mistakes, given the current demand for risk-free debt. (Though even the UK managed to get an inflationary decade in the 1970s, when it last tried to use monetary policy to manage employment amid a crisis.)
The RBI and its peers have no such room for error. Inflation targeting and independence has been a hard-won triumph. Already, the RBI has made the error of following the Western central bank fashion by deciding to try to buy up corporate paper.
Central banks are not commercial banks, and just because the Fed is pretending to be one does not mean the RBI can and should follow suit.
It definitely does not have the same level of accountability and supervision that the Fed has, for one thing.
Supporting companies during a crisis is a decision for the elected government to make through a transparent use of taxpayer money, not technocrats through a hidden future inflationary tax.
India is not so distant from years of high and entrenched inflationary expectations that it should start trying to play games with the economy the way the West’s central bankers think they are entitled to.
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