Parliament setting the target won’t make it better
It is not clear whether, when he said Parliament should set India’s inflation target, finance minister P Chidambaram was setting limits for the central bank or whether he bought into the argument of inflation-targeting by RBI. Getting Parliament to set such a target will, in itself, be a tall task given that is not easy for even economists to determine a growth-inflation trade-off. In a vacuum, it won’t be difficult for MPs to say they would like inflation to be under 5%, but the reaction would be different if it was pointed out, say, this may be accompanied by a 2 percentage point reduction in GDP.
Even if you get past this very big hurdle, getting the central bank to do only inflation-targeting is a bad idea. For one, before adopting such a model, there has to be an explanation as to why India’s multiple-indicator model went awry over the past few years after doing quite well for decades—if the problem was simply RBI taking its eye of the inflation ball for too long, the solution lies in RBI being vigilant, not in dumping the old model. Even in the US, where monetary transmission is so much faster, the Fed looks at both employment and inflation levels while conducting policy. India, by contrast, has lots of other issues that make inflation-targeting a bad idea. In the current context of extremely weak growth, for instance, were RBI to be solely focussed on inflation, it would keep raising interest rates. Indeed, when the dramatic depreciation of the rupee fuelled inflation last year, an inflation-targeting RBI would have no option but to raise rates whereas, in hindsight, it is clear that RBI’s dollar swaps for oil marketing companies and offering to defray part of hedging costs—which brought in $34 billion of valuable foreign exchange in FCNR deposits—are what helped stabilise the rupee.
There are then the issues related to structural rigidities that add to the problem of inflation control. Imperfect agriculture markets, for instance, prevent food inflation levels from coming down quickly—this is why Congress vice president Rahul Gandhi spoke of the need to remove fruits and vegetables from the domain of the APMC Act. In a situation where such rigidities cause spurts in food inflation, an RBI focussed solely on inflation-targeting would have to hike rates to such levels, it would choke off growth completely. As for the sanctity of a Parliament-determined target, as is being talked of in the case of inflation, it is worth keeping in mind we already have one such target in the fiscal deficit. The finance minister announces it in the budget, and even a medium-term target is proposed, and this is ratified by Parliament—yet, more often than not, the target is breached and, in the case of the medium-term target, simply put on hold.