Monetary Policy and Inflation TargetingModule 4
Contemporary Themes in India’s
Economic Development and the Economic Survey.
Arvind Subramanian
Chief Economic Adviser
Government of India
MINISTRY OF FINANCE
GOVERNMENT OF INDIA
1
Overview
• Objective of Monetary Policy
• Monetary Policy Transmission
• Monetary Policy Framework
• Rationale
• How it works
2
Objective of Monetary Policy
• Keep inflation and inflation
expectations low and stable
• Help stabilize economy, including
avoiding and responding to
financial crisis
4
Objective of Monetary Policy
why are price and economic stability important?
• High inflation creates uncertainty, reduces investment
and reduces economy’s supply potential
• Inflation adversely affects income distribution
• Inflation is a tax on poor
• Iron Law of Indian political-economy – Inflation more
than 5% counterproductive
5
Objective of Monetary Policy
6
1
3
5
7
9
11
13
1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
pe
r ce
nt
Indian CPI inflation
25
20
15
10
5
0
-5
-10
-15
-201914 1925 1936 1947 1959 1970 1981 1992 2004 2015
US CPI Inflation (annual percentage change, blue line) and recessions (vertical shades)
Avoid stagflation
(low GDP but high
inflation; post- oil
crisis)
Avoid deflation
(great depression)
Stabilize economy
and financial system
(global financial crisis
2008)
Objective of Monetary Policy
8
Monetary Policy Transmission 1: Interest Rate and Borrowing Channel
6
6.5
7
7.5
8
8.5
9
9.5
10
10.5
Apr.
21,
201
7
Ma
r. 3
, 2
01
7
Ja
n.
13
, 20
17
Nov. 2
5, 2
016
Oct. 7
, 2
016
Aug
. 19
, 2
016
Ju
l. 1
, 20
16
Ma
y 1
3,
20
16
Ma
r. 2
5,
20
16
Ja
n.
22
, 20
16
Dec. 4
, 20
15
Oct. 1
6,
201
5
Aug
. 28
, 2
015
Ju
l. 1
0, 2
015
Ma
y 2
2,
20
15
Ma
r. 2
7,
20
15
Fe
b.
6, 2
01
5
Dec. 1
9, 2
014
Oct. 3
1,
201
4
Sep
. 12
, 2
014
Ju
l. 2
5, 2
014
Ju
n.
6,
201
4
Apr.
18,
201
4
Fe
b.
28,
20
14
Ja
n.
10
, 20
14
Nov. 2
2, 2
013
Oct. 4
, 2
013
Aug
. 16
, 2
013
Ju
n.
21
, 20
13
Ma
y 3
, 2
01
3
Ma
r. 1
5,
20
13
Ja
n.
25
, 20
13
Dec. 7
, 20
12
Oct. 1
9,
201
2
Aug
. 31
, 2
012
Ju
l. 6
, 20
12
Ma
y 1
8,
20
12
Ma
r. 3
0,
20
12
Fe
b.
10,
20
12
Dec. 2
3, 2
011
Policy Repo Rate
Base Rate Mean
Term Deposit Rate Mean
Policy rate lending rate borrowing 10
Monetary Policy Transmission 1A: Interest Rate and Borrowing Channel, Transmission of Recent Rate Cuts
Impeded by Rising NPAs
6.0
6.5
7.0
7.5
8.0
8.5
9.0
9.5
10.0
10.5
Apr.
21,
201
7M
ar.
10
, 20
17
Ja
n.
27
, 20
17
De
c. 1
6, 2
016
Nov. 4
, 20
16
Sep
. 23
, 2
016
Aug
. 12
, 2
016
Ju
l. 1
, 20
16
Ma
y 2
0,
20
16
Apr.
8, 2
016
Fe
b.
19,
20
16
Ja
n.
1,
201
6N
ov. 2
0, 2
015
Oct. 9
, 2
015
Aug
. 28
, 2
015
Ju
l. 1
7, 2
015
Ju
n.
5,
201
5A
pr.
24,
201
5M
ar.
6,
201
5Ja
n.
23
, 20
15
De
c. 1
2, 2
014
Oct. 3
1,
201
4S
ep
. 19
, 2
014
Aug
. 8,
20
14
Ju
n.
27
, 20
14
Ma
y 1
6,
20
14
Apr.
4, 2
014
Fe
b.
21,
20
14
Ja
n.
10
, 20
14
No
v. 2
9, 2
013
Oct. 1
8,
201
3S
ep
. 6,
20
13
Ju
l. 2
6, 2
013
Ju
n.
7,
201
3A
pr.
26,
201
3M
ar.
15
, 20
13
Fe
b.
1, 2
01
3D
ec. 2
1, 2
012
Nov. 9
, 20
12
Sep
. 28
, 2
012
Aug
. 17
, 2
012
Ju
n.
29
, 20
12
Ma
y 1
8,
20
12
Apr.
6, 2
012
Fe
b.
24,
20
12
Ja
n.
13
, 20
12
Dec. 2
, 20
11
Policy Repo Rate
Base Rate Mean
Term Deposit Rate Mean
11
Monetary Policy Transmission 2: Exchange Rate Channel
6.0
6.5
7.0
7.5
8.0
8.5
9.0
0.014
0.015
0.016
0.017
0.018
0.019
0.02
0.021
No
v. 11, 2011
Jan
. 13, 2012
Mar
. 16, 2012
May
18, 2012
Jul.
27, 2012
Sep
. 28, 2012
No
v. 30, 2012
Feb
. 1, 2013
Ap
r. 5
, 2013
Jun
. 7, 2013
Aug.
16, 2013
Oct
. 18, 2013
Dec
. 20, 2013
Feb
. 21, 2014
Ap
r. 2
5, 2014
Jun
. 27, 2014
Aug.
29, 2014
Oct
. 31, 2014
Jan
. 2, 2015
Mar
. 6, 2015
May
15, 2015
Jul.
17, 2015
Sep
. 18, 2015
No
v. 20, 2015
Jan
. 22, 2016
Ap
r. 8
, 2016
Jun
. 10, 2016
Aug.
12, 2016
Oct
. 14, 2016
Dec
. 16, 2016
Feb
. 17, 2017
Ap
r. 2
1, 2017
$/Rs Repo(RHS)
Policy rate capital inflow weaker local currency (depreciation) 12
Monetary Policy Transmission 3:
Financial Savings Channel
0
2
4
6
8
10
12
14
-2
-1
0
1
2
3
4
5
6
7
8
9
Ja
n-1
2
Ma
r-1
2
Ma
y-1
2
Ju
l-1
2
Se
p-1
2
Nov-1
2
Ja
n-1
3
Ma
r-1
3
Ma
y-1
3
Ju
l-1
3
Se
p-1
3
No
v-1
3
Ja
n-1
4
Ma
r-1
4
Ma
y-1
4
Ju
l-1
4
Sep-1
4
No
v-1
4
Ja
n-1
5
Ma
r-1
5
Ma
y-1
5
Ju
l-1
5
Se
p-1
5
No
v-1
5
Ja
n-1
6
Ma
r-1
6
Real interest rate based on
average inflation of CPI and
WPI
Real Deposit growth
(RHS)
Policy Rate in deposits rate Financial Savings
13
India’s Monetary Policy Framework
• India has recently shifted to an inflation targeting framework
• Standard framework used by advanced country central banks
• What is inflation targeting (IT) all about?
15
• Money targeting?
• Exchange rate?
money demand too unstable!
increasing capital mobility, speculative attacks
• IT developed pragmatically
• Disinflation: Canada and New Zealand failed with money targeting
in 1980s, Chile with exchange-rate-based stabilization policies
• End of pegs: U.K., Sweden (1993), Czech Rep. (1997), Brazil (1999)
History of Inflation Forecast
Targeting
• Break of Bretton-Woods system in the 1970s world moved from
fixed to floating regimes need for a new nominal anchor
• Unsuccessful alternatives to IT
16
Understanding IT
• Three key elements
• Objective: inflation target
• Supporting framework: institutional arrangements
• Decision rule: central bank reaction function
17
Empirical Evidence on IT
• OECD: No significant effect on inflation average and variability
• EMEs: Lower average inflation and, typically, inflation
variability. Inflation in IT-countries has come down from a
higher level18
Three questions
• Why an inflation target?
• What institutional arrangements?
• What decision rule?
19
Three questions
• Why an inflation target?
• What institutional arrangements?
• What decision rule?
20
Many potential objectives
• Ensure stable prices
• Promote growth
• Maintain exchange rate peg
• Preserve financial stability
• Contain current account deficit
21
Second Answer
• India’s historical experience
• Question: why an inflation target now, two decades after IT became popular in the rest of the world?
• Answer: until recently, no pressing reason to change the framework. RBI had kept inflation low, close to world norms
• But after the Global Financial Crisis, world inflation collapsed, while Indian inflation soared
23
Historical Inflation: India and Others
-8
-6
-4
-2
0
2
4
6
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Inflation Differential: India and low/middle income (LMI) countries
Inflation in India
higher than LMI
countries
Inflation in India
lower than LMI
countries
24
Five years of double-digit inflation
1
4
7
10
13
16
19
Ja
n-0
7A
pr-
07
Jul-07
Oct-
07
Ja
n-0
8A
pr-
08
Ju
l-0
8O
ct-
08
Ja
n-0
9A
pr-
09
Ju
l-0
9O
ct-
09
Ja
n-1
0A
pr-
10
Ju
l-1
0O
ct-
10
Jan-1
1A
pr-
11
Ju
l-1
1O
ct-
11
Ja
n-1
2A
pr-
12
Ju
l-1
2O
ct-
12
Ja
n-1
3A
pr-
13
Ju
l-1
3O
ct-
13
Ja
n-1
4A
pr-
14
Jul-14
Oct-
14
Ja
n-1
5A
pr-
15
Ju
l-1
5O
ct-
15
Ja
n-1
6A
pr-
16
Ju
l-1
6O
ct-
16
Ja
n-1
7A
pr-
17
Inflation Repo Rate
25
IT is a promise
• IT is a commitment by the government and RBI that they will
never allow this to happen again
• To show their seriousness, they have formalised the
commitment in a law
• But why only a inflation target? What about the other
objectives?
26
Third answer
• Targeting multiple objectives is problematic
• RBI previously followed a “multiple objectives” regime; that’s how inflation
control was lost
• Tinbergen rule: for every objective, you need an instrument
• Central banks only have one main instrument – interest rates!
• Which means they can really aim at only one objective
27
What about other objectives?
• Central banks still care about:
• growth
• exchange rate
• financial stability
• How do central banks deal with these objectives under IT?
28
Growth objectives
• Growth concern: if interest rates are too high, they could “kill”
the economy
• But how can the RBI chase two targets without violating
Tinbergen Rule?
29
Divine coincidence
• Equilibrium equation: aggregate demand (planned expenditure, PE) =
aggregate supply (Y)
• If PE < Y, that means output is likely to slump and inflation will be “too low”
cut rates, cure both!
• If PE > Y, the economy is overheating and inflation will be too high
raise rates, cure both!
• Miracle: aiming for an inflation target means stabilizing economic growth
31
Caution: miracles not guaranteed!
• Assumed supply is fixed
• But what if there is a supply shock?
• Favourable (fall in oil/food price)
• Best of both worlds: inflation falls and growth rises
• Unfavourable (rise in oil/food price, possibly GST)
• Stagflation: inflation rises and growth falls conflict!
32
Dealing with supply shocks
• Priority is given to controlling inflation
• Cannot control the “first round” impact on price level
• Focus on making sure first round increase doesn’t trigger many subsequent rounds (embedded inflation)
33
Exchange rate objectives
• Exchange rate is more problematic
• Maintaining competitiveness is important
• But central banks face trilemma. Cannot have all three:
• Independent monetary policy (inflation target)
• Exchange rate target
• Free flow of capital
34
The Impossible Trilemma
Only two of the three are possible
Perfect capital mobility;
Fixed/managed exchange rate; and
Independent monetary policy (IMP)
35
The Impossible Trilemma
The Impossible Trinity
Independent
Monetary Policy
Perfect Capital Mobility
Fixed
Exchange
RateChina
36
Impossible Trilemma – Case I
Fixed/Managed
ERIMP
Restrictions on
K-mobility
4
5
6
7
8
9
10
Ja
n-0
7
Au
g-0
7
Ma
r-0
8
Oct-
08
Ma
y-0
9
De
c-0
9
Ju
l-1
0
Fe
b-1
1
Se
p-1
1
Ap
r-1
2
No
v-1
2
Ju
n-1
3
Ja
n-1
4
Aug-1
4
Mar-
15
Oct-
15
CNY/USD
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Ja
n-0
7
Se
p-0
7
Ma
y-0
8
Ja
n-0
9
Se
p-0
9
May-1
0
Ja
n-1
1
Se
p-1
1
Ma
y-1
2
Ja
n-1
3
Se
p-1
3
Ma
y-1
4
Ja
n-1
5
Se
p-1
5
Spread b/w China and US interest rate
37
Impossible Trilemma – Case II
Fixed/Managed
ER
Perfect
K-mobility
MP
independence
lost
5
7
9
11
13
15
17
0.0
1.9
3.8
5.7
7.6
9.5Ja
n-0
7
Ap
r-0
7
Ju
l-0
7
Oct-
07
Ja
n-0
8
Ap
r-0
8
Ju
l-0
8
Oct-
08
Ja
n-0
9
Ap
r-0
9
Ju
l-0
9
Oct-
09
Ja
n-1
0
Repo Rate
Fed Rate
Inflation (RHS)
39
41
43
45
47
49
51
Ja
n-0
7
Apr-
07
Ju
l-0
7
Oct-
07
Ja
n-0
8
Ap
r-0
8
Ju
l-0
8
Oct-
08
Ja
n-0
9
Ap
r-0
9
Ju
l-0
9
Oct-
09
Ja
n-1
0
Rs./US$
38
Impossible Trilemma – Case III
IMPPerfect
K-mobilityFlexible ER
12
13
14
15
16
17
18
19
20
21
2.8
3.8
4.8
5.8
6.8
7.8
8.82
00
4-0
8-0
1
200
4-1
0-0
1
200
4-1
2-0
1
200
5-0
2-0
1
200
5-0
4-0
1
200
5-0
6-0
1
200
5-0
8-0
1
200
5-1
0-0
1
200
5-1
2-0
1
200
6-0
2-0
1
200
6-0
4-0
1
200
6-0
6-0
1
200
6-0
8-0
1
200
6-1
0-0
1
200
6-1
2-0
1
CPI SELIC (RHS)
60
65
70
75
80
85
200
4-0
8-0
1
200
4-1
0-0
1
200
4-1
2-0
1
200
5-0
2-0
1
200
5-0
4-0
1
200
5-0
6-0
1
200
5-0
8-0
1
200
5-1
0-0
1
200
5-1
2-0
1
200
6-0
2-0
1
200
6-0
4-0
1
200
6-0
6-0
1
200
6-0
8-0
1
200
6-1
0-0
1
200
6-1
2-0
1
NEER
39
Possible strategies
• Capital controls: allow exchange rate targeting, but tight controls will cut off inflows needed for growth
• FX intervention: can limit exchange rate appreciation, but will inflate money supply; excessive intervention will jeopardise inflation target
• “Divine coincidence”: appreciation reduces inflation, allowing interest rates to be cut; alleviates but rarely solves problem
• No central bank has found a perfect solution. RBI relies on a mix of above.
40
Group Preference ReasonsManufacturers Low interest rates, weak currency Profits increase, even if some inputs are imported, since
market share grows. This applies both to exporters (clothing)
and to firms producing for domestic market but competing
with imports(steel, aluminium)
Domestically oriented firms Low interest rates Profits increase; debt burden declines
Infrastructure companies Strong currency Typically borrow in dollars, earn in rupees. Strong currency
contains debt service burden without affecting revenues.
Care less about domestic interest rates
Households High interest rates Greater return on savings. Household saving far outweighs
household borrowing.
Equity investors -- Domestic Low interest rates Corporate profits increase, and hence returns.
Equity investors -- Foreign Low interest rates, strong
currency
Combination boosts dollar returns. Tension: low rates
typically lead to weaker currency.
Bond investors -- Domestic Falling interest rates Generates capital gains. Banks prefer low rates; other
investors (LIC) prefer high rates.
Bond investors -- Foreign High but falling interest rates,
strong currency
Combination maximizes dollar returns. Tension: falling rates
weaken currency.
Government Low interest rates Low rates reduce debt service. Extra growth or inflation
increases revenues.
Institutional Biases on Interest Rates and Exchange Rates
41
Financial stability objectives
• Financial stability clearly important (see: Global Financial Crisis)
• Most central banks use prudential/regulatory measures to ensure
stability
• Others argue that monetary policy should also be used, to
reinforce prudential measures
• Increase rates if banks are lending excessively
• Reduce rates if banking system is under stress
42
Bottom Line
• IT means central bank has an inflation target
• Does not mean that inflation is the only objective
• Means that inflation is the primary objective
• Others can be pursued, but inflation takes precedence if a conflict arises
43
Operationalising the Target
• Once IT regime is agreed, must decide:
• particular measure of inflation to target
• specific level of inflation target
44
What Inflation Target?
3.0
3.4
3.8
4.2
4.6
5.0
5.4
5.8
6.2
Ja
n-1
5
Fe
b-1
5
Ma
r-1
5
Ap
r-1
5
Ma
y-1
5
Ju
n-1
5
Ju
l-1
5
Au
g-1
5
Se
p-1
5
Oct-
15
No
v-1
5
De
c-1
5
Ja
n-1
6
Fe
b-1
6
Ma
r-1
6
Ap
r-1
6
Ma
y-1
6
Ju
n-1
6
Ju
l-1
6
Au
g-1
6
Se
p-1
6
Oct-
16
No
v-1
6
De
c-1
6
Ja
n-1
7
Fe
b-1
7
Ma
r-1
7
CPI Headline CPI Core
45
Virtues of CPI
• CPI Headline or CPI Core?• CPI Headline includes oil and food prices whose prices cannot be controlled by
the RBI
• CPI Core basket is 47.3% of the overall CPI basket – RBI can only influence CPI core basket prices
• If so, why all central banks target CPI Headline?• CPI headline reflects the prices consumers and savers face
• Easier to communicate
• Inflation expectations are based on headline CPI inflation46
What level advanced countries target?
• Initially, IT central banks took “price stability” objective literally• Targeted inflation no more than 2 percent
• Since Global Financial Crisis, emphasis on symmetry• Tried to keep inflation near 2 percent, stimulate if too low
• Some have argued for higher target of around 4 percent, to allow highly negative real rates in case of severe recessions
47
What level target/emerging markets?• Many EM’s have targetted inflation around 4 percent, India: 2-6
percent
• Reasons
• EM’s have more bottlenecks, difficult to target very low inflation
• target would keep nominal exchange rate stable
• Maths
• Assume EM productivity growth is 2 percentage points higher than AEs,
• Then EM wage/price growth can be 2 percentage point higher without loss
of competitiveness
• So no need for nominal rate to depreciate
48
Three Questions
• Why an inflation target?
• What institutional arrangements?
• What decision rule?
49
Credibility
• Credibility is critical for central banks
• If the public doesn’t believe the central bank is committed to an
inflation target, interest rates will need to be kept high to prove
intent
• To reinforce credibility, IT central banks institutionalize their
commitment to low inflation
50
Monetary Policy Committee
• IT central banks have monetary policy committees (MPC)
• Purpose: to decide on monetary policy
• Reasons: • Better decision-making, as members bring outside views
• Better credibility, when decisions endorsed by experts
• India’s MPC:• 3 from RBI, including Governor
• 3 external members, appointed by government
• Governor has casting vote
51
Accountability
• Government will hold RBI accountable for achieving inflation target
• Any deviation for three consecutive quarters will have to be explained
• In case of a failure, RBI will have to:• Specify the reasons
• Suggest remedial actions
• Estimate the time period within which the target will be achieved
52
Transparency
• To enhance credibility, RBI explains its actions to the
public:
• Press conference
• Interviews
• Inflation report
• Speeches
53
Independence
• Independence is critical
• Government has set the policy• assigned inflation target to RBI
• RBI needs operational independence so it can achieve target
54
Operational Independence
• RBI must be free to choose appropriate interest rate
• Equally important: RBI must seen to be free
• Otherwise, decisions are seen as politically motivated
• Credibility is damaged, undermining entire exercise
55
Three questions
• Why an inflation target?
• What institutional arrangements?
• What decision rule?
56
Quiz!
• Let’s say that the inflation target is a point target of 4 percent
• What should the RBI do if inflation rises to 7 percent?
• What should it do if inflation falls to 2 percent?
57
The Importance of Lags
• Monetary policy cannot control aggregate demand instantaneously
• Effects take about 1 to 2 years
• Implication: monetary policy must be forward looking
60
Looking Forward
• Good monetary policy requires sophisticated, model-based
inflation forecast
• To assess likely path of inflation
• Appropriate interest rate path
• To guide expectations, most central banks (including RBI)
publish their inflation forecasts
• Some also publish expected interest rate path61
Judgement
• But economic models aren’t perfect; future difficult to predict
• Setting monetary policy still requires judgement
• Monetary Policy Committee can help
• But expect the unexpected: inflation will deviate from target
62
Correcting Deviations• Example:
• Target: 4 percent
• Actual: 7 percent
• Question: when should inflation return to target
• Problem 1: try to return to target too soon, high interest rates will “kill”
economy
• Problem 2: adopt gradual approach, high inflation will become entrenched,
and require very high interest rates to eradicate
63
Inflation Forecast Targeting
• Central banks cannot and should not attempt to always achieve inflation target
• Instead, they should target their inflation forecast
• Meaning: set policy in way that target is expected to be achieved over 2 year policy horizon
• Better name: inflation forecast targeting (IFT)
64
Possible Evolution in Inflation Targeting
• Nominal GDP Target
• Forward Guidance
• Olivier Blanchard Solution
65
Answers• Why an inflation target?
• Maintaining price stability is the fundamental objective of central bank
• Other objectives can be pursued, as long as they don’t pose a conflict
• What institutional arrangements?
• Monetary Policy Committees
• Accountability
• Transparency
• Operational independence
• What policy strategies?
• Forward looking,
• Policymaking is difficult, requires careful assessment and judgement66
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