Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 4 - Monetary Policy and Inflation

Introduction

It is now widely agreed that monetary policy can contribute to sustainable growth by maintaining price stability. Price stability, in turn, may be defined as a rate of inflation that is sufficiently low that households and businesses do not have to take it into account in making everyday decisions. High inflation has an adverse effect on growth due to a number of factors: distortion of relative prices which lowers economic efficiency; redistribution of wealth between debtors and creditors; aversion to long-term contracts and excessive resources are devoted to hedging inflation risks. In developing economies, in particular, an additional cost of high inflation emanates from its adverse effects on the poor population. Maintenance of low and stable inflation has thus emerged as a key objective of monetary policy and a noteworthy development during the 1980s and the 1990s was the reduction in inflation across a number of countries, irrespective of their stages of development. This reduction in inflation is believed to be on account of improvements in the conduct of monetary policy, although there is an ongoing debate on this in view of other factors such as globalisation, deregulation, competition and prudent fiscal policies that might have also played a role. In advanced economies, inflation rates in the recent decade have averaged around 2-3 per cent per annum - consistent with the establishment of reasonable price stability. In developing and emerging economies too, inflation rates have declined significantly.

The current phase of low global inflation is comparable with the pre-World War II phenomenon when inflation rates across regions were quite low. In the post-World War-II period, however, price levels showed a clear upward trend, with inflation rates rather than price levels clustering around a stationary level following price shocks. In particular, the collapse of the Bretton Woods arrangement was associated with a surge in inflation during the 1970s. Commodity price shocks, especially oil prices, coupled with expansionary demand management policies including Vietnam-war related fiscal expansion in the US provided a significant impetus to inflation. The belief that there existed a stable long-run trade-off between inflation and output as well as overestimation of potential output also contributed to the accommodative stance of monetary policies during this period. With inflation in double digits, deliberate disinflation strategies were put in place in a number of advanced economies during the 1980s and these were successful in reducing inflation. In particular, co-ordinated fiscal and monetary policies were deployed to curtail demand pressures in the economy.

Ongoing improvements in the conduct of monetary policy and other economic reforms helped to reduce inflation further during the 1990s. Structural reforms in labour markets, increased competition brought in by the forces of globalisation and fiscal consolidation contributed to low inflation. In order to keep inflation as well as inflation expectations low and stable, efforts to improve monetary-fiscal coordination have been strengthened through emphasis on fiscal rules.

Low and stable inflation - called the 'Death of Inflation' - has been accompanied with a relatively higher stability in economic activity and the period has been termed as a NICE - Non-Inflationary Consistently Expansionary - decade. However, low levels of inflation can also be a source of concern. Inflation during 2001-03 had fallen to such low levels in various countries following the global slowdown that it raised concerns of a generalised deflation. Aggressive monetary policy easing, however, prevented a generalised deflation. More recently, with signs of economic recovery, central banks have started withdrawing monetary stimuli in a measured manner.

The world has thus experienced a significant rise and fall in inflation. Concomitantly, the past half-century has also seen major changes in monetary policy frameworks. The debate on 'rules' versus 'discretion' led to a renewed focus on price stability by central banks, and issues such as central bank independence have come to the forefront. A number of central banks have adopted explicit inflation targets under an inflation targeting (IT) regime.

Like other economies, India too witnessed a rise in inflation during the 1970s and 1980s reflecting a mix of expansionary fiscal policy, accommodative monetary policy and supply shocks. In the aftermath of the balance of payments difficulties, inflation rose further during the first half of the 1990s reflecting a variety of factors. Improved monetary-fiscal interface and other reforms imparted greater flexibility to the Reserve Bank in its monetary management since the mid-1990s, even though it had to contend with large capital flows. Equipped with abundant food stocks and foreign exchange reserves, the Reserve Bank has been able to contain inflation. Significant success in reining in inflation has helped to lower inflation expectations while the tolerable level of inflation has also come down.

Against this background, this Module covers issues related to the final objective of monetary process, viz., price stability. Section I(articles 2 to 5) examines the international inflation record of the last half-century - the rise during the 1970s and the subsequent moderation. It undertakes a critical assessment of the various factors leading to this inflation behaviour. The brief experience till date of inflation targeting framework is critically analysed. Issues such as the conduct of monetary policy in a low inflation environment in the context of the recent threat of deflation, growth-inflation trade-off and exchange-rate pass-through to domestic prices are also addressed. Finally, this Section undertakes an assessment of the impact of oil shocks on economic activity and inflation. Section II (remaining articles) focuses on the behaviour of inflation in India. It explores various factors that led to inflationary pressures during the 1970s and 1980s and the subsequent containment since mid-1990s. Relevance of core measures of inflation and inflation targeting for an emerging economy like India is critically assessed. In view of recent divergence between alternative indicators of inflation, an empirical exercise is undertaken to examine their long-run behaviour. Finally, the Section attempts to model inflation process in India. In view of the growing openness of the Indian economy coupled with a market-determined exchange rate system, an attempt is also made to estimate pass-through of exchange rate to domestic inflation.

This Module has undertaken an assessment of the inflation record of the past half-century. Consensus has emerged that monetary policy can contribute to growth and employment by ensuring price stability - defined as low and stable inflation. In the short-run, supply shocks can lead to large changes in the headline inflation. However, persistent high inflation is ultimately the outcome of lax monetary policies - as witnessed during the 1970s. With inflation in double digits, central banks in advanced economies adopted deliberate disinflation strategies beginning in the late 1970s. Monetary policies were tightened and industrial economies could reduce inflation significantly by the second half of the 1980s, albeit at costs of large output and employment losses. Developing countries have also been able to reduce inflation during the 1990s as fiscal consolidation and structural reforms provided flexibility to monetary policy in meeting its price stability objective. The experience with inflation targeting frameworks is evolving - both IT and non-IT countries have been successful in reducing inflation during the 1990s. Many EMEs have also adopted IT. Their performance is quite impressive when judged in terms of the reduction in inflation although they have not been always able to meet their inflation targets. However, compared with many advanced economies, their performance is relatively weaker, reflecting additional constraints on these economies. Moreover, the stylised fact of the 1990s has been that not only IT countries but even non-IT countries have been able to reduce inflation. The jury is still out on the extent to which inflation targeting policies have actually contributed to the reduction in inflation that has occurred. Exchange rate pass-through to domestic prices has declined during the 1990s for advanced as well as developing economies, inter alia, due to success of monetary policy in maintaining a low and stable inflation environment.

Overall, improvements in the institutional setup of monetary policy - independent central banks, better communication strategies, increased transparency, improved techniques - have been a key factor contributing to low and stable inflation although the relative role of monetary policy per se in containing inflation continues to be matter of debate. Prudent fiscal policies, structural reforms, productivity growth, deregulation, globalisation and competition have also contributed in achieving the low inflation environment. A reversal in the trend of any of these above factors can, in turn, be a threat to this low inflation environment. As discussed in Module: 3, current global macroeconomic imbalances and concomitant adjustment dynamics present one such threat to price stability. Evolving demographics - rising elderly populations in advanced economies - pose a new challenge to fiscal authorities. The concomitant rising public debt can be a threat to the present low inflation environment. A prudent fiscal policy remains the single largest pre-requisite for monetary stability. Monetary arrangements per se have only limited power to fix real problems arising from a fiscal regime inconsistent with the goal of price stability (IMF, 2002). Efforts towards fiscal consolidation have, therefore, been strengthened with clear-cut fiscal rules. Successful monetary policy involves shaping market expectations of the way in which inflation and other critical variables are likely to evolve. The various reforms in the monetary policy arena since 1980s such as central bank independence, accountability through clear-cut targets and transparency have been progressively aimed at enhancing the credibility of the central banks in order to stabilise inflation expectations. Once inflation expectations are stabilised firmly, temporary shocks to current inflation do not have any adverse impact on long-run inflation expectations.

In India, inflation increased from the 1970s onwards before moderating in mid-1990s. Expansionary fiscal policy during the 1980s and its monetisation were a major cause of the increase in inflation. Structural reforms since the early 1990s coupled with improved monetary-fiscal interface and reforms in Government securities markets enabled better monetary management since the second half of the 1990s. The expansionary effect emanating from massive capital flows to India since 1993-94 has been effectively sterilised through a variety of instruments.including open market sales of Government bonds and repo operations under liquidity adjustment facility. Judicious use of innovative instruments such as the Market Stabilisation Bills/Bonds was resorted to manage liquidity conditions consistent with the objective of price stability. Thus, notwithstanding the unprecedented order of external capital flows, monetary management was effective in ensuring a reduction in inflation and lowering inflation expectations. There is a widespread agreement that the record of the Reserve Bank in monetary management has been, on balance, satisfactory. The degree of credibility that the Reserve Bank has earned over time is in itself likely to be an effective instrument of monetary policy in meeting the challenges of the future.

The success with achieving and maintaining low inflation in India since mid-1990s has led to a number of positive developments. First, there is virtually a national consensus that high inflation is not good and that it should be brought down. Second, inflation expectations have come down and, consequently, inflation tolerance has also come down. As the global experience shows, it is very important to keep inflation expectations low. Inflation expectations, inter alia, depend upon fiscal prudence. It is, therefore, essential to pursue fiscal consolidation, promptly and with resolve, from a medium-term perspective. Transparent and monitorable fiscal rules assume importance in this context. The recently enacted Fiscal Responsibility and Budget Management Act by the Central Government with its envisaged reduction in key deficit indicators is expected to reduce the fiscal dominance over time and will provide the Reserve Bank necessary flexibility so as to maintain low and stable inflation. It would be necessary to put in place similar fiscal responsibility rules at State levels. Adherence to these fiscal rules will help to stabilise inflation expectations and keep inflation low and stable in the country.