Is ‘flexible inflation targeting’ (FIT) ripe for a coup d’état that topples its almost three-decade grip on the ruling dispensations of central banks the world over? Pioneered by New Zealand as early as 1990, and soon emulated by Canada and the United Kingdom, FIT is now the de jure, or de facto, monetary policy of most major advanced and emerging market central banks, including the Reserve Bank of India (RBI).
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Doubts about whether FIT was fit for the purpose began to grow after the global financial crisis of 2007-2009 and its aftermath. A monetary policy fixated solely on consumer price inflation (CPI), or some variant, failed to react to asset price bubbles that eventually burst and threatened to topple the entire global monetary and financial edifice.
As it happens, FIT largely survived that initial barrage. This was partly because, despite its limitations, no other monetary policy framework that might be a credible replacement was proposed by FIT’s legion of critics. It was a bit like disliking the government one had, but liking the alternative options even less. Plus, inflation stayed tame in the aftermath of that crisis, and attention was focused on unconventional policies such as ‘quantitative easing’ to pump liquidity into financial markets. This pushed debates on FIT largely onto the back burner.
There was also a sense that regulatory policies—so-called ‘macroprudential’ policies—would be better suited to the cause of keeping asset price bubbles in control, while the policy interest rate should remain focused on CPI, or another nominal anchor such as nominal gross domestic product.
Ironically, economic dislocations caused by the covid pandemic may end up having a more profound impact on the consensus around monetary policy alternatives to FIT than a financial crisis linked directly to monetary policy a little more than a decade earlier. Again, in the initial aftermath of this crisis, with a collapse in aggregate economic activity in all major economies, there was little fear of an uptick in inflation. Central banks across the world doubled down on unconventional policies, and governments began to roll out massive doses of fiscal stimulus in most advanced and emerging economies.
But, now that the world is on track toward vaccination, lockdowns are easing and green shoots of an economic recovery are becoming visible, alarm bells are starting to ring, at least dimly and distantly for now. In the United States, the stimulus proposal by President Joe Biden, which has a jaw-dropping price tag of $1.9 trillion, has caused even centre-left, Keynesian-oriented economists to take note and urge caution. Leading this charge is Lawrence Summers, a Harvard economics professor, former treasury secretary under president Bill Clinton and a key economic policy advisor to former president Barack Obama.
Meanwhile, Olivier Blanchard, a former chief economist of the International Monetary Fund, argues—as quoted in The Wall Street Journal—that the Biden stimulus is so large that it would represent “an increase in demand that I have not seen in my lifetime”; there is a danger that unemployment may be driven down to 1.5%, well below the ‘natural’ rate at which inflation would stay stable, and the stimulus is thus, in Blanchard’s view, potentially very inflationary. For his part, Summers calls the Biden stimulus an entry into “entirely unprecedented territory”.
As it happens, fears of a return of inflation make the case for sticking with FIT more compelling. After all, the policy was designed to bring an end to the almost two decades of erratic monetary policy, which followed the collapse of the Bretton Woods system in 1971, when America’s then president Richard Nixon closed the “gold window”, effectively killing the system of fixed exchange rates that had given the world much-needed monetary stability since its creation after World War II. The ‘stagflation’ fiasco of the 1970s—an era of economic recession and high inflation—and the failed experiment with monetary targeting in many advanced economies in the 1980s, which resulted in erratic inflation outcomes, propelled both academic economists and central bankers towards FIT in the 1990s.
In an important shift, the US Federal Reserve recently modified its inflation target to focus on average inflation. This means that periods of inflation below target could be compensated for with a phase of inflation above target, so that inflation hits an average target over a given span of time. This would eliminate the asymmetry caused by the fact that—once FIT was adopted and the public’s inflationary expectations got baked in around the Fed’s target—inflation has more often than not undershot rather than overshot its aim in the US.
Still, not all central bankers are equally sanguine. In an important recent speech, Andy Haldane, Bank of England’s chief economist, has warned that taming inflation, if it flares up again, may be akin to trying to catch a “tiger by the tail”, borrowing an expression coined by libertarian economist, Friedrich von Hayek, who was always hawkish on inflation and sceptical of the government’s ability to fine-tune business cycles (and the wisdom of trying to do this).
At this juncture, it would be salutary to remind ourselves that the stagflation crisis of the 1970s occurred partly because of complacency over inflation heating up. FIT may not be ideal, but it is still the best among our current choices (many of which are significantly worse) of a monetary policy framework.
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Steve Ovett, the famous British middle-distance athlete, won the 800-metres gold medal at the Moscow Olympics of 1980. Just a few days later, he was about to win a 5,000-metres race at London’s Crystal Palace. Known for his burst of acceleration on the home stretch, he had supreme confidence in his ability to out-sprint rivals. With the final 100 metres remaining,
[wptelegram-join-channel link=”https://t.me/s/upsctree” text=”Join @upsctree on Telegram”]Ovett waved to the crowd and raised a hand in triumph. But he had celebrated a bit too early. At the finishing line, Ireland’s John Treacy edged past Ovett. For those few moments, Ovett had lost his sense of reality and ignored the possibility of a negative event.
This analogy works well for the India story and our policy failures , including during the ongoing covid pandemic. While we have never been as well prepared or had significant successes in terms of growth stability as Ovett did in his illustrious running career, we tend to celebrate too early. Indeed, we have done so many times before.
It is as if we’re convinced that India is destined for greater heights, come what may, and so we never run through the finish line. Do we and our policymakers suffer from a collective optimism bias, which, as the Nobel Prize winner Daniel Kahneman once wrote, “may well be the most significant of the cognitive biases”? The optimism bias arises from mistaken beliefs which form expectations that are better than the reality. It makes us underestimate chances of a negative outcome and ignore warnings repeatedly.
The Indian economy had a dream run for five years from 2003-04 to 2007-08, with an average annual growth rate of around 9%. Many believed that India was on its way to clocking consistent double-digit growth and comparisons with China were rife. It was conveniently overlooked that this output expansion had come mainly came from a few sectors: automobiles, telecom and business services.
Indians were made to believe that we could sprint without high-quality education, healthcare, infrastructure or banking sectors, which form the backbone of any stable economy. The plan was to build them as we went along, but then in the euphoria of short-term success, it got lost.
India’s exports of goods grew from $20 billion in 1990-91 to over $310 billion in 2019-20. Looking at these absolute figures it would seem as if India has arrived on the world stage. However, India’s share of global trade has moved up only marginally. Even now, the country accounts for less than 2% of the world’s goods exports.
More importantly, hidden behind this performance was the role played by one sector that should have never made it to India’s list of exports—refined petroleum. The share of refined petroleum exports in India’s goods exports increased from 1.4% in 1996-97 to over 18% in 2011-12.
An import-intensive sector with low labour intensity, exports of refined petroleum zoomed because of the then policy regime of a retail price ceiling on petroleum products in the domestic market. While we have done well in the export of services, our share is still less than 4% of world exports.
India seemed to emerge from the 2008 global financial crisis relatively unscathed. But, a temporary demand push had played a role in the revival—the incomes of many households, both rural and urban, had shot up. Fiscal stimulus to the rural economy and implementation of the Sixth Pay Commission scales had led to the salaries of around 20% of organized-sector employees jumping up. We celebrated, but once again, neither did we resolve the crisis brewing elsewhere in India’s banking sector, nor did we improve our capacity for healthcare or quality education.
Employment saw little economy-wide growth in our boom years. Manufacturing jobs, if anything, shrank. But we continued to celebrate. Youth flocked to low-productivity service-sector jobs, such as those in hotels and restaurants, security and other services. The dependence on such jobs on one hand and high-skilled services on the other was bound to make Indian society more unequal.
And then, there is agriculture, an elephant in the room. If and when farm-sector reforms get implemented, celebrations would once again be premature. The vast majority of India’s farmers have small plots of land, and though these farms are at least as productive as larger ones, net absolute incomes from small plots can only be meagre.
A further rise in farm productivity and consequent increase in supply, if not matched by a demand rise, especially with access to export markets, would result in downward pressure on market prices for farm produce and a further decline in the net incomes of small farmers.
We should learn from what John Treacy did right. He didn’t give up, and pushed for the finish line like it was his only chance at winning. Treacy had years of long-distance practice. The same goes for our economy. A long grind is required to build up its base before we can win and celebrate. And Ovett did not blame anyone for his loss. We play the blame game. Everyone else, right from China and the US to ‘greedy corporates’, seems to be responsible for our failures.
We have lowered absolute poverty levels and had technology-based successes like Aadhaar and digital access to public services. But there are no short cuts to good quality and adequate healthcare and education services. We must remain optimistic but stay firmly away from the optimism bias.
In the end, it is not about how we start, but how we finish. The disastrous second wave of covid and our inability to manage it is a ghastly reminder of this fact.