In Defence Of Flexible Inflation Targeting
As Covid has shown, India’s flexible inflation targeting framework is broad enough to respond strongly to near-term growth shocks
Central banking has been revolutionised over the last decade and particularly during Covid-19. But even in this brave new world of central banking, flexible inflation targeting remains the most viable framework for emerging markets.
Shock And Awe
When the post-mortem on Covid-19 is eventually conducted, the role of central banks in mitigating the economic fallout is likely to figure prominently.
The scale and scope of the intervention has been unprecedented. G-4 central banks have led the charge. Apart from quickly slashing overnight rates to zero, these central banks increased their balance sheets by an incredulous 20% of GDP in just the Covid-year. That scale was matched only by its scope. Quantitative Easing was complemented with Credit Easing as central banks found ways to lend directly to corporations and households and liquefy virtually every market.
The lessons of the two biggest economic crisis over the last century had been firmly incorporated. The Great Depression had revealed how central bank diffidence served to amplify the original shock. The Global Financial Crisis revealed how an array of unconventional monetary instruments could be deployed when short rates hit the zero lower bound. Armed by these lessons and a new playbook, central banks came out swinging.
This demonstration effect was not lost on emerging markets.
Despite overnight policy rates still much above zero, many EM central banks began QE to anchor the yield curve, provided extensive regulatory forbearance, and injected a glut of liquidity. A once-in-a-century crisis required a commensurate response and central banks stepped up to the plate.
No Panacea
But do central banks risk becoming a victim of their own success?
There is a growing belief that monetary policy can serve as a panacea. That it can compensate for inadequacies or dysfunction in other parts of the system. It cannot. While it has played a crucial role in softening the economic blow from Covid-19, the monetary response does not come without risks or limitations.
The first is the challenge of exit. The Powell Doctrine from the Gulf War famously spoke about not entering without a clearly thought-out exit strategy. We’ve seen how difficult exit has been over the last decade. QE during and immediately after the GFC meant G-4 balance sheets had grown to 20% of GDP by 2010.
Despite the global economy growing steadily over much of the next decade, however, the size of these balance sheets had doubled to 40% of GDP by 2019, pre-Covid, as shown in the table below. All this during peace time!
True, the G4 economies had not witnessed any inflation. But the glut of global liquidity has meant surging asset price inflation, a growing and irreconcilable disconnect with ground realities, and concerns about a systematic mispricing of risk that could eventually have financial stability implications.
Given the sustained intervention in bond markets which has impeded price discovery, will these markets be able to function healthily again absent this support? How disruptive will that transition be? Keeping a patient on ventilatory support longer-than-required is deemed to be counter-productive because it diminishes the lungs’ ability to function normally again. Will central banks ever be able to wean away the ventilator?
A second limitation is the imperfect substitutability between fiscal and monetary policy. Monetary policy had to do too much of the heavy lifting after the Global Financial Crisis because fiscal policy became too restrictive too soon in some parts of the world, reflecting political dysfunction in Europe and the U.S. But relying excessively on monetary policy creates the distortions enumerated above.
Furthermore, by inflating asset prices and pushing down the cost of capital beyond a point, monetary easing risks accentuating the societal inequities between capital and labour and also distorting the factor-input mix. Against this backdrop, fiscal policy has an even more crucial role to play to redress these balances. For these reasons, it’s important that fiscal policy is not tightened too soon post-Covid, thereby leaving an even greater onus on central banks.
Finally, monetary policy can act as a cyclical stabiliser, but it cannot alter underlying potential growth. That requires the harder slog of boosting productivity, increasing allocative efficiency and undertaking structural transformation – a distinction that’s often forgotten.
If It’s Good For The Goose…
These risks and limitations are not necessarily unknown. What’s perhaps new in the aftermath of Covid-19 is a growing debate that emerging market central banks – having successfully adopted unconventional techniques during the crisis – should broaden their mandate more permanently.
If they could simultaneously manage output, bond yields, exchange rates and financial stability during the crisis, why not do so more durably? Isn’t a narrow focus on inflation targeting too limiting in this brave new world of central banking? The answer, of course, is no, for a myriad of reasons.
First, in the long run, there is no trade-off between growth and inflation, so diluting focus on inflation is counter-productive in that it hurts medium-term growth prospects.
Second, as the Covid-19 crisis has revealed, a flexible inflation targeting framework – like the one India has adopted – offers enough latitude for central banks to focus on a myriad of different objectives during a shock without necessarily compromising its medium-term inflation credentials.
Third, adding more objectives permanently is only feasible if (i) they don’t conflict with each other and (ii) policymakers are able to identify new instruments to address these objectives. Recall, the time-tested Tinbergen Principle that a system must have as many (relatively orthogonal) instruments as it has objectives. Else it is under-determined. Finding new instruments is not easy and goes to the heart of policy trilemma. This objectives-instruments mismatch in emerging markets is an under-appreciated constraint, and one that is much more binding than in developed economies who both benefit from exorbitant privilege and don’t target their exchange rates.
If It Ain’t Broken…
Let us address each of these issues in more detail.
Elevated inflation being incompatible with long-run growth should be self-evident. High inflation is typically also volatile inflation, causing gyrations in the internal terms of trade, putting downward pressure on the Rupee, stoking macroeconomic uncertainty and thereby vitiating the investment environment. Therefore, no country has seen sustained high growth when also afflicted with high inflation. Elevated inflation by hurting the poor – whose incomes are typically least indexed to inflation – also exacerbates inequities. Central banks, therefore, don’t contemplate raising their inflation targets, because it ends up being self-defeating in the medium term.
Second, flexible inflation targeting – as India has adopted – already gives central banks plenty of latitude to respond to shocks. The assigned weights to growth and inflation in any Taylor Rule are expected to be dynamic and contextual. India’s CPI has averaged almost 7% over the last year – above the 6% upper band – yet no one was surprised that the RBI slashed interest rates and injected a glut of liquidity this year. Responding to an unprecedented growth shock was the appropriate response during the crisis. Despite inflation being elevated, markets understood and accepted this imperative. There were no capital outflows and inflation risk premia in bonds and swaps did not spike.
That said, as the shock fades and particularly if inflation remains sticky, markets would expect the Taylor Rule weights to be rebalanced towards achieving the medium-term inflation target, and the exceptional crisis-induced measures (forbearance, liquidity) to be gradually, and non-disruptively, reversed. This way the RBI would have shown its nimbleness to respond effectively to a shock without compromising its medium-term inflation credentials.
The Tinbergen Test
So if growth-inflation dynamics are already embedded into a flexible inflation targeting framework and financial stability objectives can be achieved through regulatory and macro-prudential instruments, what more flexibility is needed?
If, indeed, other objectives must be added, then new instruments must be found. Central banks typically use a combination of policy rates and liquidity injection/withdrawal to target overnight interbank rates – the operating target of monetary policy. This operating target is calibrated to the prevailing inflation and growth objectives. Adding objectives is only sustainable if it doesn’t distort this operating target.
For example, a central bank can simultaneously target the exchange rate if any forex intervention is sterilised (either through forward intervention or by draining the resulting liquidity) to ensure the operating target of monetary policy is not distorted. Here too, there is no free lunch. Sustained forward intervention pushes up the forward premia that may disincentivise hedging, and withdrawing liquidity, by pushing up short rates, can attract more speculative capital inflows – which goes to the heart of the trilemma.
This just goes to show how challenging it is to add more objectives to growth and inflation because of the difficulty of finding orthogonal policy instruments.
Fiscal Dominance
Fiscal dominance will create its own challenges in a post-Covid world. As public debt levels have swelled, market pressures to anchor bond yields -- and thereby make public debt more sustainable – will only rise around the world. But making this a permanent objective of monetary policy fundamentally conflicts with an inflation objective.
If inflation is above target, for instance, central banks will eventually be forced to tighten liquidity and short rates, which will impact long-end yields. So one cannot credibly commit to simultaneously targeting inflation and bond yields across all states of nature.
To be sure, DM central banks are also subject to fiscal dominance, but the constraint is less binding because inflation has been below target for years. Therefore, pushing down bond yields can still be justified as trying to ease monetary conditions to achieve the inflation target, even if the true motivation is linked more to fiscal dominance. EM central banks don’t have that luxury when inflation is above target.
One final pushback towards inflation targeting is that central banks can’t influence inflation. Then why target it. This presumes that central banks cannot impact the demand and supply curves curve and output gaps. But if they cannot influence demand and supply then, by construction, they cannot impact activity and growth either. Monetary policy becomes redundant and the debate is moot.
All told, as Covid has shown, India’s flexible inflation targeting framework appears broad enough to respond strongly to near-term growth shocks. As the shock fades, however, it will be important to recalibrate policy consistent with the medium-term inflation target.
Exchange rate objectives can also be largely accommodated, if the intervention is sterilised, while financial stability considerations can be addressed through judicious use of regulatory and macro-prudential instruments.
Adding yet more objectives, without first identifying policy instruments, is either likely to conflict with existing objectives, and create internal inconsistency, or create a framework that’s underdetermined, and therefore unviable.
It’s no wonder flexible inflation targeting has endured the test of time around the world.
Sajjid Z Chinoy is Chief India Economist at JPMorgan. All views are personal.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.