If It’s Good For The Goose…

These risks and limitations are not necessarily unknown. What’s perhaps new in the aftermath of Covid-19 is a growing debate that emerging market central banks – having successfully adopted unconventional techniques during the crisis – should broaden their mandate more permanently.

First, in the long run, there is no trade-off between growth and inflation, so diluting focus on inflation is counter-productive in that it hurts medium-term growth prospects.

Second, as the Covid-19 crisis has revealed, a flexible inflation targeting framework – like the one India has adopted – offers enough latitude for central banks to focus on a myriad of different objectives during a shock without necessarily compromising its medium-term inflation credentials.

Third, adding more objectives permanently is only feasible if (i) they don’t conflict with each other and (ii) policymakers are able to identify new instruments to address these objectives. Recall, the time-tested Tinbergen Principle that a system must have as many (relatively orthogonal) instruments as it has objectives. Else it is under-determined. Finding new instruments is not easy and goes to the heart of policy trilemma. This objectives-instruments mismatch in emerging markets is an under-appreciated constraint, and one that is much more binding than in developed economies who both benefit from exorbitant privilege and don’t target their exchange rates.

Let us address each of these issues in more detail.

Elevated inflation being incompatible with long-run growth should be self-evident. High inflation is typically also volatile inflation, causing gyrations in the internal terms of trade, putting downward pressure on the Rupee, stoking macroeconomic uncertainty and thereby vitiating the investment environment. Therefore, no country has seen sustained high growth when also afflicted with high inflation. Elevated inflation by hurting the poor – whose incomes are typically least indexed to inflation – also exacerbates inequities. Central banks, therefore, don’t contemplate raising their inflation targets, because it ends up being self-defeating in the medium term.

Second, flexible inflation targeting – as India has adopted – already gives central banks plenty of latitude to respond to shocks. The assigned weights to growth and inflation in any Taylor Rule are expected to be dynamic and contextual. India’s CPI has averaged almost 7% over the last year – above the 6% upper band – yet no one was surprised that the RBI slashed interest rates and injected a glut of liquidity this year. Responding to an unprecedented growth shock was the appropriate response during the crisis. Despite inflation being elevated, markets understood and accepted this imperative. There were no capital outflows and inflation risk premia in bonds and swaps did not spike.

That said, as the shock fades and particularly if inflation remains sticky, markets would expect the Taylor Rule weights to be rebalanced towards achieving the medium-term inflation target, and the exceptional crisis-induced measures (forbearance, liquidity) to be gradually, and non-disruptively, reversed. This way the RBI would have shown its nimbleness to respond effectively to a shock without compromising its medium-term inflation credentials.

So if growth-inflation dynamics are already embedded into a flexible inflation targeting framework and financial stability objectives can be achieved through regulatory and macro-prudential instruments, what more flexibility is needed?

If, indeed, other objectives must be added, then new instruments must be found. Central banks typically use a combination of policy rates and liquidity injection/withdrawal to target overnight interbank rates – the operating target of monetary policy. This operating target is calibrated to the prevailing inflation and growth objectives. Adding objectives is only sustainable if it doesn’t distort this operating target.

For example, a central bank can simultaneously target the exchange rate if any forex intervention is sterilised (either through forward intervention or by draining the resulting liquidity) to ensure the operating target of monetary policy is not distorted. Here too, there is no free lunch. Sustained forward intervention pushes up the forward premia that may disincentivise hedging, and withdrawing liquidity, by pushing up short rates, can attract more speculative capital inflows – which goes to the heart of the trilemma.

This just goes to show how challenging it is to add more objectives to growth and inflation because of the difficulty of finding orthogonal policy instruments.

Fiscal dominance will create its own challenges in a post-Covid world. As public debt levels have swelled, market pressures to anchor bond yields — and thereby make public debt more sustainable – will only rise around the world. But making this a permanent objective of monetary policy fundamentally conflicts with an inflation objective.

If inflation is above target, for instance, central banks will eventually be forced to tighten liquidity and short rates, which will impact long-end yields. So one cannot credibly commit to simultaneously targeting inflation and bond yields across all states of nature.

To be sure, DM central banks are also subject to fiscal dominance, but the constraint is less binding because inflation has been below target for years. Therefore, pushing down bond yields can still be justified as trying to ease monetary conditions to achieve the inflation target, even if the true motivation is linked more to fiscal dominance. EM central banks don’t have that luxury when inflation is above target.

One final pushback towards inflation targeting is that central banks can’t influence inflation. Then why target it. This presumes that central banks cannot impact the demand and supply curves curve and output gaps. But if they cannot influence demand and supply then, by construction, they cannot impact activity and growth either. Monetary policy becomes redundant and the debate is moot.

Exchange rate objectives can also be largely accommodated, if the intervention is sterilised, while financial stability considerations can be addressed through judicious use of regulatory and macro-prudential instruments.

Adding yet more objectives, without first identifying policy instruments, is either likely to conflict with existing objectives, and create internal inconsistency, or create a framework that’s underdetermined, and therefore unviable.

It’s no wonder flexible inflation targeting has endured the test of time around the world.

Sajjid Z Chinoy is Chief India Economist at JPMorgan. All views are personal.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.



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