Wednesday, 3 February 2016

Let the rupee slide

Indian Express, 3rd February 2016

The economy is best served by lowering interest rates and blocking protectionism.

In its monetary policy announcement on Tuesday, the Reserve Bank of India (RBI) decided to keep the policy interest rate unchanged. One of the implications of this decision is for the rupee. High interest rates have helped in keeping the rupee strong in recent years. It appears policymakers wish this to continue.

But the recent slowdown in China and the depreciation of the yuan means India's external environment has changed significantly. While two years ago it might have seemed like a good idea to prevent the rupee from weakening, a rethink is now warranted.

In recent months, Indian industry has been facing sharp competition from falling international prices. As the budget-making process starts, demands for tariff hikes will get stronger. Accepting protectionist demands could impact downstream industries and have implications for India's international treaty obligations. Favouring certain sectors, especially those with a few large companies, can make the protection politically difficult.

One example of this is the steel industry where the world's largest producer of steel, China' has seen a slump in demand and has an industry suffering from overcapacity. The Indian steel industry is faced with an onslaught of cheap imports. It has, in response, been pressing for hikes in import duty on steel, imposition of a minimum import price and anti-dumping duties.

It can be argued that the government should do nothing, and allow the Indian consumer to benefit from lower Chinese steel prices. However, it is difficult for the government to ignore the state of the steel industry and job losses. The consequent higher probability of defaults on bank loans by steel companies may also push banks into further trouble.

Already, India is ranked No 1 in imposing the most protectionist measures since 2008. In 2015, India imposed the second highest number of protectionist measures, after Russia. For the fastest growing economy in the world, the policy of greater protectionism is becoming untenable.

We expect that in 2016 the pressure for protectionist measures may increase. Global trade has slowed down to nearly zero per cent growth. As the Chinese economy and Chinese exports slow down, Chinese authorities may to try to help push exports.

For one, the Chinese renminbi was devalued. For years, the Chinese currency had seen pressure to appreciate. The slowdown, the pressure on exports and China's decision to depreciate seem to have set off an outflow of dollars from China. Today, the pressure is for greater depreciation. The pace of depreciation has been slowed by foreign exchange intervention. China has been selling dollars. We have seen a decline in its foreign exchange reserves by $513 billion in 2015. In the month of December 2015 alone, China's reserves fell by $108bn. With higher pressure to increase exports, China may allow the yuan to depreciate more.

The most likely direction of the yuan is downwards. In response, other emerging economies are also weakening their currencies. It is not difficult for an emerging market (EM) to do a currency depreciation in today's environment. It does not require cutting interest rates, out of line with macroeconomic conditions. Global growth has slowed down and commodity deflation is putting downward pressure on prices. Following the increase in US interest rates by the Federal Reserve, emerging economies have been witnessing outflows of capital. This is putting pressure on EM currencies to weaken. Indeed, today it is harder for an EM central bank to prevent a depreciation than to allow it.

If other currencies depreciate, it will further make India's imports cheaper and increase the demand for trade protection. However, tariffs are not the only way to protect domestic industry. As is being seen globally, an alternative approach to raising tariffs to tackle the loss of competitiveness of domestic industry is currency depreciation. In the above example, the impact of a 10 per cent depreciation is equivalent to a 10 per cent tariff on all steel imports. Depreciation increases the price of imported goods.

Last week, when Japan adopted a negative interest rate strategy, currency considerations are understood to have played a significant role. While deflation has been around in Japan for a while, the challenge from the yuan and the decline in commodity prices is new. The cut in Japanese policy rates will, it is hoped, depreciate the Japanese yen and increase import prices.

Today, when other countries are protecting themselves by allowing currency depreciation, should India lean against the wind? Should we combine a strong rupee policy with protectionism?

Allowing the rupee to depreciate has further benefits: It makes all imports more expensive. The government does not have the politically difficult job of increasing tariffs case by case. A weaker rupee would also help push Indian exports.

From 2009 to 2013, in the period of high volatility in the global economy, India had a largely flexible exchange rate policy. Since May 2013, India's exchange rate policy has been to prevent significant appreciation or depreciation. Since the taper talk and expectation of rupee depreciation in May 2013, an increase in interest rates and liquidity tightening have prevented any significant weakening of the rupee. Debt flows have been large as the differential between domestic and international interest rates remains high.

Everyone does not want a weak rupee. Foreign investors applaud the strong rupee policy as it protects their returns. Rich Indians like cheap foreign holidays and imported goods. For some people, a strong rupee is a matter of pride. However, the policy of keeping the rupee strong and combining it with protectionist trade measures is unsustainable. Exchange rate policy and strategy for 2016 cannot be the same as it was before the Chinese story started unfolding. The RBI and the commerce ministry need to be on the same page. The government must take a holistic view of the policy strategy on protectionism, the exchange rate and interest rates. The Indian economy would be better served by lower interest rates, blocking protectionism and letting the market determine the price of the rupee.

Monday, 18 January 2016

Be tight-fisted

Indian Express, 18th January 2016

The 'tight fiscal, easy monetary' policy mix can better address problems that plague private investment.

The finance ministry has stressed that it will stick to the path of fiscal consolidation. This is good news. While a move away from the announced targets to give the economy a stimulus may have seemed attractive in light of the signs of slower growth, the policy would not have been the most suitable for reviving investment, the biggest challenge facing the economy.

After the mid-year review suggested that fiscal targets may need to be revised, many economists emphasised the benefits of staying put on the announced path of fiscal consolidation. First, the debt to GDP ratio would remain under control. Equally important, the finance minister would maintain his credibility, particularly since he has already deviated once from the path. The decision of the government to stick to the path of the announced fiscal targets is good not just in the long run. It is also more likely to help in the short term.

One immediate gain of sticking to the path of consolidation will be to create space for monetary policy easing. The sharp decline in global commodity prices and the slowdown in demand in the domestic economy have reduced inflationary pressures. The policy interest rate - that is, the repo rate - stands at 6.75 per cent. Unlike, say, in Europe, where there is no scope for cutting the policy rate that is near zero, in India, there is ample scope to cut it. But while in principle the policy rate can be reduced significantly, the question is how to give monetary policy the space to do so.

A fiscal stimulus would increase the likelihood of demand rising and pushing up the inflation forecast. While deciding the policy interest rate, monetary policymakers target the forecast of inflation and analyse the pressures of demand on core inflation. With a slowdown in global demand, investment and domestic deman, a greater easing of the stance of monetary policy may be more possible today than perhaps even a year ago. This opportunity could be lost if the government had chosen to pursue a policy of fiscal expansion.

Monetary easing in the last one year has been cautious. A number of factors were responsible for this. One, the United States Federal Reserve was expected to raise interest rates in 2015, which could impact volatility in financial markets, especially currency markets. Two, there was a sharp increase in the prices of food items like onions and pulses, feeding into higher food inflation. Three, right at the beginning of the year, the government moved away from the path of fiscal consolidation. The fact that the policy rate was eased by only 125 basis points over the year, though inflation fell by about 500 basis points, can partly be explained by fears of rising inflationary pressures later. Today, when the Fed has finally raised rates and food inflation is expected to remain within control, deviating from the path of fiscal consolidation could keep fears of inflationary pressure alive and keep monetary easing cautious.

A loose fiscal policy would, therefore, have effectively meant that policymakers would be choosing the "loose fiscal, tight money" policy mix. This is sometimes justified by arguing that, given the poor transmission of monetary policy in India, its impact is limited compared to that of public investment, which involves direct spending by the government and raises demand instantly. While, in theory, this may hold, there are two reasons this may not be true in India today.

First, the capacity of the government to spend is limited. A large share of the capital expenditure allocated in Budget 2015 is yet to be spent. Many good plans have been approved and money allocated, but the shovel is yet to hit the ground. While, in theory, public investment can spur private investment' limited state capacity may be one reason why the magnitude and lags involved may make this strategy less optimal than theory suggests.

Second, private companies are unable to repay the interest on their debt. Banks are increasingly seeing loans get in trouble. High interest rates hurt not just the companies whose revenue growth has fallen sharply but also banks whose stressed assets have been on the rise. For private investment to pick up, companies need to have the ability to borrow, and banks the ability to lend. Raising demand through a fiscal stimulus does not address the balance-sheet stress of companies and banks, while a reduction in interest rates would.

Early in 2015, the government and the RBI adopted inflation targeting as an objective of monetary policy. Inflation targeting is adopted by governments and central banks to tie down their own hands. The benefit of low inflation goes to the elected government that gains by way of providing a low-inflation environment to citizens. While endless arguments can be made about the effectiveness of monetary policy in India, the efficiency of the transmission mechanism, the role of food inflation, and so on, there is little doubt that the objective of low inflation is consistent with the preferences of the bulk of the population. The suggestion made by some economists that the government should rethink and review its commitment to inflation targeting, instead of finding ways to meet it, is unwise.

The best strategy for the government, therefore, lies not in giving up the inflation target, or in changing the measure of inflation adopted, the consumer price index, because it is higher than the wholesale price index, or in changing the glide path towards the target, but in creating the conditions that would keep inflationary pressures down.

In the present context, adhering to the announced path of fiscal consolidation would allow the "tight fiscal, easy monetary" policy mix that is more suited to addressing the troubles that plague private investment. The RBI should respond to this commitment by cutting interest rates. There is clearly no magic bullet for reviving investment. However, a reduction in the interest burden could possibly prevent more companies from going towards bankruptcy. This is a greater need of the hour than higher demand.

Monday, 7 April 2014

No escape from freedom

Indian Express, 3rd March 2014

A closed capital account is not a real option. We should focus on sequence and timing.

In his article, 'Against the flows' (IE, February 24), Gulzar Natarajan said capital controls were good and necessary. Liberalising our capital account, he claimed, will not benefit India either through higher growth or investment. It will only result in currency crises and higher risks, which we cannot manage.

India must, therefore, not liberalise its capital account - even the IMF has endorsed this line of reasoning according to Natarajan. But this argument ignores India's de facto capital account openness, the aspirations of a young and ambitious country, which does not want to go back in time, and the enormous body of evidence on the failure of capital controls as a tool of macroeconomic policy.

Economists like to think that there is a debate about capital account openness and that a decision about whether it should be open or closed is yet to be made. But this is not what happens in the real world. In the real world, a maturing country develops a capable financial system and sophisticated firms. It develops a liberal democracy, where the government is unable to interfere in the freedom of citizens. Once a country reaches this state of maturity, the capital account is de facto open.

Whether some economists think it should be open or not, in the eyes of the top 10 per cent of India - which makes decisions for the bulk of the economy - the capital account is open. To close it requires intruding on personal freedoms, inflicting harm on internationalised firms, and damaging the financial system.

When some Indian bureaucrats have argued in favour of a closed capital account at international forums, they have faced amusement from the audience. No country has taken this idea seriously. This so-called "lesson from the global financial crisis" is something no one is interested in learning. There has been no reduction in capital account openness - either among advanced countries or among emerging markets - after the crisis. The free movement of goods, services, ideas, capital and enterprise across national borders is an integral part of modernity.

Capital controls in emerging economies, where they exist, are like tariff or non-tariff barriers that can be switched on and off. They can be price- or quantity-based. Most evidence shows that these controls have little usefulness, both in terms of the time period for which they are actually effective, and in terms of their macroeconomic impact, which is limited and short-lived.

Advocates of capital controls have argued that their failure to deliver results is because they have been temporary. It is contended that permanent controls, which intrude deeply in the functioning of the economy, would work better. India is a rare laboratory that permits restrictions on capital flows.

The present Indian framework is a complex licence-permit raj. It is unlike what is found almost anywhere else in the world. We, in India, know that complex licence-permit systems always work badly, and are almost allergic to the thousands of pages of detailed restrictions.

Have Indian capital controls been effective? The effectiveness of controls is an often-misunderstood concept. We should measure whether they were able to achieve the objective that they were imposed for. If the all-in-cost ceiling for external commercial borrowings (ECB) was reduced from Libor plus 400 basis points to Libor plus 200 basis points, then the question to be asked is not whether borrowing went down. Instead, it should be whether this decision was able to achieve the objective of the restriction - for example, to reduce net inflows. All too often, companies respond to controls by simply changing the garb in which the same capital flows.

If companies moved from pure debt under ECB to foreign currency convertible bonds, the same money would come into India under a different name. One could then wrongly argue that the controls were effective because flows under ECB declined after restrictions were imposed. But the original objective - reducing overall inflows - was not met. Careful analyses of effectiveness have demonstrated that the Indian framework has not delivered on the objectives of macroeconomic policy.

Natarajan's article is about the least interesting end of the capital account openness puzzle. There are two interesting questions to be asked. First, in what order and sequence should controls be removed? Second, what auxiliary actions should India undertake in order to become resilient to the new challenges that an open capital account introduces? If you have air travel, you will have plane crashes, and the country will need to develop the institutional capability to respond to crises. It is interesting and important to understand the regulatory framework required for aircraft and airports. But surely, nobody would propose that we should not have planes.

This takes us to the territory of technical questions that generally do not fit neatly in opinion pieces. What does prudent foreign borrowing mean? Should rupee-denominated debt continue to be more restricted than foreign currency-denominated debt? How can companies be encouraged to hedge their currency risk? How can we help markets for hedging develop? And so on. These are the interesting questions in the field of capital controls - not ideological sloganeering about whether capital account liberalisation is good or bad.

To a significant extent, this is about generational change. One generation ago, it was interesting and fashionable to discuss whether India should liberalise its capital account or not. Things have changed. We are now a $2 trillion economy, with capable global firms, with aspirations for a sophisticated financial system, with a liberal democracy that makes it infeasible for the government to arbitrarily restrict the freedoms of citizens. In such a country, what merits attention is the sequence and timing of capital account liberalisation, and the establishment of institutional capability for fiscal, financial and monetary policy.

Hold on to interest rates

Financial Express, 1st April 2014

The impact of tighter fiscal and monetary policy on inflation is now visible in the recent price data. Inflation, measured both by the wholesale price index and by the consumer price index, has come down. It may still be too early to cut rates, but RBI Governor Raghuram Rajan can now afford to hold rates unchanged in today's monetary policy announcement. His strategy of an aggressive attack on inflation, despite the scepticism often voiced in the Indian monetary policy debate about the effectiveness of monetary policy, was the right strategy and is yielding results.

Considering that inflationary expectations in India are high and persistent, and could take a while to come down, Rajan should not cut the repo rate as yet. If the WPI inflation measure is the target, there is a case for cutting rates since this has come down sharply. However, the CPI, the target towards which the RBI sensibly appears to be moving, is still above 8% and there is fear that it may go up due to unseasonal rains. Also, CPI based inflation has not remained low long enough for inflationary expectations to fall.

The fiscal and monetary contraction of the last 9 months, as well as the slowdown in the economy, have contributed to the reduction in inflation. In this environment, effective communication by RBI that its focus will be on inflation control, has played an important role. In addition, the setting up of the Urjit Patel committee and its view that RBI should adopt inflation targeting has helped counter some of the traditional RBI view that monetary policy has no impact on inflation, that India has a weak monetary policy transmission mechanism so there is no point in trying to raise rates, that inflation in India cannot be measured properly and so on.

The war on inflation is still not won. The present dip in inflation must be sustained for many months before RBI can relax. Despite the fall in GDP growth, the consequent slowdown in demand, and the fall in commodity prices, Indian inflation is higher than what is seen elsewhere in the world. Inflation in food has contributed most, but inflation in non-food has also been sticky.

Looking forward, there is a contradiction between RBI's aggressive stance on inflation and its intervention in the foreign exchange market. RBI's stance on monetary policy could be undermined by its intervention in the foreign exchange market. In recent weeks, RBI appears to be intervening in the foreign exchange market to prevent the rupee from appreciating. The extent of intervention and its sterilisation is not known yet. If the intervention is unsterilised, then it would lead to an increase in liquidity and would pull down interest rates even without a monetary policy announcement. Indeed since RBI's monetary policy is not conducted only through the interest rate instrument, but also through its intervention and sterilisation, something that the Governor does not announce with the policy stance, it has been seen in the past that while actions on the policy rate move in one direction, the liquidity conditions in the market can move in quite the opposite direction. This was the story of the mid-2000s, when RBI was intervening in the foreign exchange market to combat rupee appreciation and raising the repo rate at the same time to fight inflation. Its intervention was only partly sterilised and was pumping liquidity into the system pushing up inflation. As a consequence, the policy rate hikes were ineffective.

Inflation targeting countries usually solve this problem by adopting a flexible exchange rate. In other words, the exchange rate is allowed to move, while inflation is stabilised. Sometimes there may be occasional sterilised intervention by the central bank. However, central banks that target inflation do not pursue pegged exchange rates for long periods. This means that they do not require resources for sustained sterilisation. While the Urjit Patel committee has proposed that RBI target inflation, it has also proposed that the central bank should get unlimited sterilisation powers. Occasional foreign exchange intervention and sterilisation to contain volatility do not require unlimited sterilisation capacity. If RBI is move to an inflation targeting framework, it cannot plan to do unlimited sterilisation. The People's Bank of China, the Chinese central bank, which targets the exchange rate, has such powers. Other central banks do not have such powers as these are inconsistent with the mandate of inflation targeting. In other words, if RBI is to seriously adopt inflation targeting, it must give up on pegging the exchange rate. Trying to target inflation and exchange rate simultaneously on a sustained basis is inconsistent.

A further consideration in the decision about the stance of monetary policy would be global liquidity considerations. Janet Yellen's recent comments suggest that the US Fed could start raising rates next year. As long as the US monetary policy remains unconventional, i.e., until the time comes when the FOMC discusses and decides policy interest rates rather than the purchase of bonds, it remains in uncharted territory. Low inflation, along with a low current account and fiscal deficit, would be a more prudent policy, as there could be sharp and sudden changes in US and global liquidity conditions. This may prompt RBI to keep interest rates unchanged.

Open up the capital account

Financial Express, 15th March 2014

India's path to capital account convertibility will be an important question for the new government. Left thinkers have attacked financial globalisation, pointing to the risks it brings to emerging economies, especially after the financial crisis. For the new India with world class multinationals, with a skilled labour force and the potential for becoming an international financial centre, the Left arguments perpetuate backwardness. The next government needs to move forward with rationalisation, liberalisation, removal of bureaucratic overhead, and establishing the rule of law so that Indian companies and citizens have greater freedom to manage their finances and access to world-class products and lowest prices. Missteps on this process will generate shocks to the exchange rate and to the economy.

India has a large and complex system of permanent and pervasive capital controls. Numerous agencies have been given powers to interfere with cross-border transactions. It is often not clear why certain controls are in place. For India to succeed, the relevant question is: How to open up sensibly?

The first element for policy is the hygiene of good governance. The principles of transparency, accountability and rule of law, which have gained prominence across all parts of the working of the state, are equally relevant here. Across the landscape, there is unhappiness about the bureaucratic overhead faced in doing simple things-it is time to slash the red tape and simplify procedures. This is just the hygiene of sound public administration. The government is in the process of voluntarily implementing the governance-enhancing features of the Indian Financial Code that was drafted by Financial Sector Legislative Reforms Commission (FSLRC). These will yield major gains when applied to the working of capital controls.

Percy Mistry, whose report argued for making Mumbai an international financial centre, has long reminded us that there are no accidents on a village road not because the traffic police is effective, but because there is no traffic. Whether we should have financial globalisation is no longer a question for India. The question now is: How can we open up to the world and, at the same time, undertake measures to become strong and

resilient? For example, steps to increase the liquidity of derivatives markets, removing caps on rupee-denominated debt and enabling firms to hedge their foreign currency exposure will make the economy more

resilient. Engagement with the world introduces new risks-and the best way to deal with those risks is to have deep and liquid markets as shock absorbers. So far, RBI has prevented the emergence of a deep and liquid market for the exchange rate and for bonds. This needs to be reversed.

In the minds of some policy makers, there is the idea that capital controls can be switched off and on at will, based on the movement of the exchange rate that is desired. This idea is flawed at numerous levels.

First, the existing evidence shows that these attempts at tinkering with capital controls do not yield the desired impact on the exchange rate. The hoped-for outcome is not realised.

Second, there are important costs. To make an analogy, consider the export of onions. If India repeatedly switches off and on the export of onions, this frustrates the development of sophisticated firms with long-range contracts and a deep understanding of the international onion trade. In fact, the very possibility that a government might shut off a business hinders firms from investing in developing those capabilities. If the government threatened that they would shut down barber shops in the future at whim, there would be fewer and inferior barber shops.

Participation in the global onion trade requires complex firms with a rich network of human networks and long-term contracts. So it is with international financial activity. For Indian firms to grow roots in global finance, and for global firms to grow roots in India, both sides have to invest considerable amounts in the long-term objective of building organisational capability. When India indulges in a ban, this kills off organisational capability. When India even threatens to impose a ban in the future, investments in building this capability are reduced.

The defining problem in a safe and sound engagement with financial globalisation is that of overcoming asymmetric information. When the global financial system does not have a deep understanding of India, it is more likely to make mistakes, with capital surges, sudden stops, mistakes in investment flows, knee-jerk responses to events, etc. To avoid these maladies, we require that global financial firms have a deep knowledge of India. This deep knowledge is impounded in the organisational capital of global financial firms: in their staff, in their processes, in their long-term investments in learning India. But for this to happen, we have to stop banning cross-border activity and change laws so that there is no possibility of bans in the future.

To simplify the complex system we have, we need to ask what is the objective of each and every control in place and to undertake the task of steadily dismantling unnecessary restrictions. Some controls were put in place to prevent capital from flowing in and while others were imposed to prevent capital from flowing out. These channels of flows get circumvented by investors and overall inflows and outflow occur based on economic conditions, but the restrictions create distortions. The task is challenging, but necessary for India to become globally competitive.

With an eye on inflation

Indian Express, 14th February 2014

Flexible inflation targeting is the best way to dent price rise.

India is the only large emerging market (EM) that doesn't currently have a monetary policy framework. Other than China, which targets the exchange rate, all large EMs target inflation. This is one of the main reasons why India saw a rise in inflation after the global financial crisis, while other EMs experienced a downward pressure on prices. It is clear to students of monetary economics that an inflation-targeting framework is the way forward for India, which is opening up its capital account and moving towards a flexible exchange rate regime.

India has chosen these two corners of the trinity - and this allows it to have an independent monetary policy. The lack of a monetary policy framework is a recipe for high inflation, low growth and highly volatile business cycles. The Urjit Patel report to revise and strengthen the monetary policy framework has recommended that the RBI adopt flexible inflation targeting.

What are the main elements of inflation targeting? First, a monetary policy framework requires a defined nominal anchor. There are many factors that determine the relative price of any two goods, while the nominal anchor determines the general level of prices. So, for example, if there are only two goods in an economy, and one costs double the other, what determines whether the prices are Rs 10 and 20 or Rs 100 and 200? When economies started using paper money, it became possible to create an unlimited amount of money. But this could cause these prices to rise to Rs 1,000 and 2,000 or any other such combination.

When paper money was anchored to gold or silver, or, in some cases, to the sterling or dollar, this used to determine the general level of prices. However, when these systems ran into trouble, countries chose a general price level as the anchor, with some allowance for changes in relative prices. A small amount of growth in the general price level allows for smooth changes in relative prices. Thus, the price level and a small, specified increase in it became the nominal anchor. This was the inflation target.

Such an anchor incentivises households to save. It allows businesses to plan, knowing how their cost structure will evolve over the years. After 1990, inflation targeting was adopted by 34 countries. The OECD countries were among the first to adopt it and, after 2000, a number of emerging economies such as Brazil, Chile, Colombia, South Africa, Thailand, South Korea, Mexico, Peru, the Philippines, Indonesia, Turkey and many east European countries followed suit.

More recently, after the global financial crisis, even developing countries started adopting this framework. After 2008, we have seen countries like Georgia, Moldova, Albania, Botswana and, in 2011, Uganda adopt inflation targeting. The fruits of the framework have been enjoyed by emerging economies. While all EMs are suffering from a slowdown in demand, India is suffering from stagflation. None of the other large EMs is experiencing such high inflation. None of them has such unanchored inflationary expectations.

Some people suggest that GDP growth should serve as the nominal anchor. But this is not possible. If it were, several countries would have already targeted growth and become rich. Countries with the highest inflation, like Zimbabwe, would also have been the fastest growing ones. An inflation-targeting framework takes into account the effect of various demand and supply shocks on inflation, output and exchange rates, and accordingly forecasts inflation, which the central bank then tries to bring back to the target rate in the medium run. For those interested in the details, Rudrani Bhattacharya and I have a recent paper on how an inflation-targeting framework would work in India.

The paper presents a typical forecasting and policy analysis model, which shows how an inflation-targeting framework takes into account various cyclical factors that impact aggregate demand and supply to forecast inflation. One of the main problems with the public discourse on inflation targeting is that it assumes inflation-targeting central banks only look at past inflation and adjust rates accordingly, rather than figuring out how demand, supply and expectations impact inflation. As the Urjit Patel report argues, while there is a tradeoff between inflation and growth in the short run, there is no tradeoff in the medium run, and cross-country evidence suggests that low and stable inflation is, in fact, better for growth. No country has given up on an inflation forecast in its monetary policy framework.

The proposed flexible inflation-targeting framework also takes into account the difficulties India faces due to high and volatile food prices. In other emerging economies also, food accounts for a high proportion of the consumption basket. The report argues for the consumer price index, of which food is a large component, to be used as the measure of the nominal anchor. A CPI inflation target of 4 per cent, which can be breached by 2 percentage points on either side, will allow the RBI not to respond if inflation is above 4 per cent but within the target band, as long as this is because of supply shocks that will not persist. With the inclusion of food inflation in the target, its spillover into non-food inflation will reduce, keeping overall CPI inflation in check even if there are spikes in food inflation.

However, it should be elected representatives, and not unelected central bankers, who decide what the nominal anchor and monetary policy framework should be. Once decided, the central bank should be given the power to pursue these objectives and it should be made accountable to the democratic representatives of the people. Eventually, in India too, as in most other countries, the monetary policy framework must be enshrined in law. This was also the opinion of the Financial Sector Legislative Reforms Commission. In the meanwhile, the proposed framework is a huge step forward. It is in accordance with the voluntary adoption of governance-enhancing principles that regulators are embracing till the Indian Financial Code is legislated upon.