The Myths of Inflation Targeting

A democracy is only as good as its journalists. The rule of one vote for one person is dangerous when people are misinformed, willfully or willingly. This may have been what Winston Churchill had in mind when he observed in the House of Commons, a couple years after his rude ejection by the British public, that democracy is the worse form of government except for all the others. He might also have been reminiscing over one of democracy's greatest scars: election night, March 5, 1933. Though less deep, the scars keep on coming. In his 1973 hit song, Sweet Home Alabama, Lynyrd Skynyrd reminds us "in Birmingham, they love the Gov'nor." The Russian electorate's love affair with Vladimir Putin has made a mockery of the constitution's term limits. George W. Bush was elected not once but twice, and the second time round was after the Iraq invasion had gone horribly, predictably wrong.

New information technology has heralded an enormous democratization of information. With some irony, this has crushed the business model of honest reporting. By and large, the more connected a country is, the more press talent and standards have been hollowed out. India has not yet suffered the worst of it, but in many other places, journalism is a career but no longer a profession. Democracy is the victim. In the United States and Europe, the best journalists with a few stubborn exceptions are the older ones who haven't left because they don't know how to do anything else. These guys will die journalists. Think Andrew Jennings who brought down FIFA's Sepp Blatter or Nick Davies who humbled Rupert Murdoch. Which young journalist do you know who dreams of being Edward Snowden or Chelsea Manning, who have given up their freedom to lay bare the illegal and immoral activities of the military?

Today, many of those who call themselves journalists behave as if their job is to closely scrutinize every serious issue until they come across a piece of titillating trivia not yet picked up and therefore deserving of being plastered over the front page or dominating the 24-hour news cycle.

Too often this describes the international and much of the local press coverage of the proposal to give the authority to set Indian interest rates to a monetary policy committee of which the governor of the Reserve Bank of India will be just one member. Where is the deep discussion of whether inflation targeting makes sense for India, the world's largest democracy and the economic rival to China? Or, if it does make sense, does a range of 2 percent to 6 percent make any sense? Or, is this not so much about economic policy than good governance?

The theory is that setting a simple inflation target for an operationally independent committee to hit will give greater credibility to monetary policy, and, by reducing the need for the level of interest rates to demonstrate seriousness, a better inflation versus growth trade-off will be delivered in the short-run, boosting growth.

This hodge-podge of Keynesian and monetarist traditions is assumed to be so self-evident that few ever care to look at the evidence. The strongest conclusion that can be drawn of the evidence is that it is weak. If you were to run a statistical correlation between growth and central bank independence over the past 10 years for the G-20 countries the correlation will be negative—the fastest growing countries have the least independent central bank. Correlation is not causation. However, a 2011 International Labour Office study ("Should Developing Countries Target Low, Single Digit Inflation to Promote Growth and Employment?", Employment Sector Employment Working Paper No. 87) shows inflation-targeting emerging economies have higher inflation rates and lower growth rates than noninflation targeters.

It could be that those driven to inflation targeting have been so because of high inflation and low growth or because monetary policy credibility is not as critical to growth as thought. Or it could be that what the data is telling us is the truth: Simple inflation targeting lowers growth in developing countries. The source of inflation matters. Inflation targeting makes most sense if the source of inflationary pressures is related to whether demand is over or above its potential, and this is perhaps most common in advanced economies.

Developing countries and India are characterized by external supply-side constraints. If inflation rises above target because of a rise in drought-affected food prices, then raising interest rates will reduce growth without impacting the source of inflation. A study by Ricardo Brito and Brianne Bystedt ("Inflation Targeting in Emerging Economies: Panel Evidence", Journal of Development Economics, 2010, volume 91, issue 2, pages 198-210), looking at a panel sample of 46 developing countries, found evidence for inflation targeting reducing growth. Developing countries also tend to be prone to both fiscal dominance (big government deficits that are financed with the support of the central bank) and financial bubbles and crashes, and in these circumstances, monetary policy can pretend to be about inflation, but it cannot be prized apart from fiscal policy, and sooner or later markets understand that.

Operating monetary policy in a world of supply shocks, fiscal dominance and financial bubbles requires great, impartial, expert judgment— the kind of judgment that is best delivered by a committee of five or seven experts—Ajay Shah makes this point most incisively—and whose deliberations are made public at some point, if not contemporaneously. An impartial view of the evidence is that what India needs is a seven-person monetary policy committee that sets interest rates, with the guiding principle of supporting price stability and orderly growth, but not an inflation target. The part of this subject that should have received most discussion by the press has received least; and the part that should have received the least has received the most.