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1 WPS (DEPR): 07 / 206 RBI WORKING PAPER SERIES Inflaion-Forecas Targeing For India: An Ouline of he Analyical Framework Jaromir Benes Kevin Clinon Asish Thomas George Joice John Ondra Kamenik Douglas Laxon Praik Mira G.V. Nadhanael Hou Wang Fan Zhang DEPARTMENT OF ECONOMIC AND POLICY RESEARCH NOVEMBER 206

2 The Reserve Bank of India (RBI) inroduced he RBI Working Papers series in March 20. These papers presen research in progress of he saff members of RBI and are disseminaed o elici commens and furher debae. The views expressed in hese papers are hose of auhors and no ha of RBI. Commens and observaions may please be forwarded o auhors. Ciaion and use of such papers should ake ino accoun is provisional characer. Copyrigh: Reserve Bank of India 206

3 Inflaion-Forecas Targeing for India: An Ouline of he Analyical Framework Jaromir Benes, Kevin Clinon, Asish Thomas George, Joice John, Ondra Kamenik, Douglas Laxon, Praik Mira, G.V. Nadhanael, Hou Wang, and Fan Zhang Absrac India formally adoped flexible-inflaion argeing (FIT) in June 206 o place price sabiliy, defined in erms of a arge CPI inflaion, as he primary objecive of he moneary policy. In his conex, he paper draws on Indian macro-economic developmens since 2000 and he experience of oher counries ha adoped FIT o bring ou insighs on how credible policy wih an emphasis on srong nominal anchor can reduce he impac of supply shocks and improve macroeconomic sabiliy. For illusraing he key issues given he unique srucural characerisics of India and he policy opions under an FIT framework, he paper describes an analyical framework using he core Quarerly Projecion Model (QPM). Simulaion of QPM are carried ou o illusrae he moneary policy responses under differen ypes of uncerainy and o bring ou he imporance of gaining credibiliy for improving moneary policy efficacy. JEL Classificaion: E5, Z0 Keywords: forecasing, economic projecions, macroeconomic models The paper is he oucome of he echnical collaboraion beween RBI and IMF o develop a quarerly projecion model for India. The auhors would like o express heir sincere hanks o B.K Bhoi, Siikanha Paanaik, Muneesh Kapur, Rajesh Singh, Rudrani Bhaacharya and anonymous referees for valuable commens on he paper. The auhors would also like o express heir graiude for he commens received from he paricipans of he Deparmen of Economic and Policy Research (DEPR) sudy circle presenaion series. The views expressed in he paper are aribuable o he auhors only and do no necessarily represen hose of he insiuions o which hey belong. All oher usual disclaimers apply. Corresponding auhor:

4 Inflaion-Forecas Targeing for India: An Ouline of he Analyical Framework I. Inroducion This paper oulines an analyical framework for he implemenaion of flexibleinflaion argeing (FIT) in India. I follows upon he recommendaions of he Exper Commiee o Revise and Srenghen he Moneary Policy Framework Repor (January 204) 2, he subsequen Agreemen on Moneary Policy Framework by Governmen of India and RBI on February 20, and he amendmen of he Reserve Bank of India Ac in May 206 paving he way for he adopion of flexible inflaion argeing framework for moneary policy and he consiuion of a Moneary Policy Commiee 4. Afer providing a broad overview of he FIT framework, he paper provides a brief accoun of he macroeconomic developmens since 2000s o highligh he macro-economic challenges faced by moneary policy a differen phases. This is followed by a brief discussion on he inernaional experiences wih implemenaion of he FIT and he insighs ha could be useful in implemenaion of he framework in he Indian conex. Thereafer, he paper discusses he key challenges in adoping FIT in India, given is unique srucural characerisics. The deails of core quarerly projecion model (QPM) wihin he FIT are presened hereafer wih illusraions on how he core-qpm could be used o hink abou moneary policy response o various scenarios including supply shocks. The final secion provides he conclusions. This paper needs o be read along wih he companion paper Benes e al. (206) 5 which implemens a full scale producion version of he QPM for India. The core QPM described in his paper draws heavily on he producion-qpm for is overall srucure and calibraions and as such much of he validaion of he core- QPM is based on he producion-qpm given in Benes e al. (206). While he producion-qpm goes ino a high level of deph in erm of inflaion processes, reamen of shocks and moneary policy ransmission of he economy, he focus of core-qpm described in his paper is o have an analyical discussion on opimal moneary policy responses under an FIT framework in an economy faced wih considerable uncerainies; boh in erms of shocks and in erms of underlying srucural facors condiioning he moneary policy ransmission. An overview of he FIT regime is discussed in Secion II. Secion III presens a narraive of he inflaion 2 Henceforh Exper commiee 3 See GoI (205) 4 See GoI (206) 5 Benes e al., 206, Quarerly Projecion Model for India: Key Elemens and Properies, Reserve Bank of India Working Paper WPS 08/206.

5 process in India in he pas decade and half. Counry experiences on FIT are presened in Secion IV followed by Secion V which describes he key challenges in implemening FIT in India. Secion VI presens he core-qpm and Secion VII presens some policy simulaion based on core-qpm. Secion VIII concludes. II. Flexible Inflaion Targeing: An Overview Since he cenral bank s own forecas conains all he informaion i possesses relevan o he oulook for inflaion including policymaker s preferences regarding he shor-run rade-off beween oupu and inflaion, as well as he esimaed effecs of shocks working heir way hrough he economy i depics an ideal inermediae arge for moneary policy over he relevan policy horizon. Therefore, inflaion-forecas argeing (IFT) is sysemaic, operaional, flexible inflaion argeing 6 (Box ). A successful policy regime provides an anchor o all nominal values, resuling in a significan reducion of uncerainy. The appropriae analyical framework works back from his anchor, and provides moneary policy wih feasible medium-erm pahs consisen wih i. In paricular, i allows for he derivaion of pahs for he policy rae which guide he shor-erm ineres rae in a way ha he inflaion objecive is achieved 7. In his framework he policy ineres rae has o be endogenous, deermined ulimaely by he goal oherwise he sysem has no nominal anchor. Acual inflaion a any poin of ime may no be equal o he arge wihin FIT as here are muliple shocks ha affec inflaion. There is a clear recogniion ha i would ake ime o bring inflaion back o he arge afer a shock, given he lagged effecs of moneary policy hrough he ransmission mechanism. As a medium erm framework, i is imporan o recognize ha occasional deviaions from he glide pah should no be inerpreed per se as moneary policy errors ha require correcion. The acual speed a which inflaion adjuss o he long-run arge would depend on he naure and magniude of shocks hiing he economy and he response of moneary policy. 6 The erm inflaion forecas argeing is due o Svensson (997). 7 This paper assumes ha he cenral bank ses policy rae wih he objecive of keeping shor-erm marke rae of ineres a any desired level. Cenral banks normally have close conrol only over a very shor-erm ineres rae, ypically an overnigh rae (e.g. he federal funds rae in he Unied Saes). In advanced economies his has an overriding influence on money marke ineres raes in general and hence a significan influence over he longer-erm raes affecing households and firms. These linkages are weaker in developing economies such as India one of he challenges discussed below. 2

6 Box : Six Principles of Inflaion Targeing. The primary role of moneary policy is o provide a nominal anchor (i.e. low, sable long-run inflaion expecaions) for he economy; he weighs given o any oher objecive mus be consisen wih his. 2. Effecive inflaion-argeing has beneficial firs-order effecs on welfare by reducing uncerainy, anchoring inflaion expecaions and reducing he incidence and severiy of boom-bus cycles. 3. Fiscal and oher governmen policies may make he ask of moneary policy easier and more credible, or more difficul and less credible. 4. Because of lags in he moneary ransmission mechanism, and concern for deviaions of oupu from poenial, as well as of inflaion from he long-run arge, following shocks i is no desirable o aim a keeping inflaion exacly on arge. 5. In view of possible shor-run rade-offs beween he inflaion arges and oher objecives, he conduc of moneary policy mus have sufficien independence from he poliical process o achieve he announced objecives. 6. Effecive monioring and accounabiliy mechanisms are required o ensure ha cenral banks behave in a manner consisen wih announced objecives and sound pracice. Adaped from Freedman and Laxon (2009). III. Three Recen Phases of Inflaion in India: A Macroeconomic View The change in moneary policy framework in India owards FIT has o be seen in he conex of macroeconomic developmens ha preceded his major developmen. Since 2000, a closer examinaion of he Indian economy indicaes ha i underwen hree disinc phases wih differen inflaion rajecory and policy response (Figure ). 3

7 Figure :Macro-Narraive of Inflaion in India Phase I Phase II Phase III 2002Q2 2002Q4 2003Q2 2003Q4 2004Q2 2004Q4 2005Q2 2005Q4 2006Q2 2006Q4 2007Q2 2007Q4 2008Q2 2008Q4 2009Q2 2009Q4 200Q2 200Q4 20Q2 20Q4 202Q2 202Q4 203Q2 203Q4 204Q2 204Q4 205Q per cen Oupu Gap CPI (RHS) Policy Rae (RHS) WPI (RHS) *Year/year. Combined CPI since 202; pre-202, backcas using re-weighed CPI-IW daa. Source: Auhors calculaions. Phase I: Moderae Inflaion and Srong Growh, In 998, India adoped a muliple indicaor approach 8 as he moneary policy framework agains an earlier regime of moneary argeing in India. The policy operaed wihou an explici nominal anchor bu wih low and sable inflaion as one of he prime objecives and using ineres raes as he primary source of moneary policy ransmission. Though he Reserve Bank used a slew of secoral Consumer Price Indices (CPIs) and he all India Wholesale Price Index (WPI) o undersand price movemens, moneary policy communicaion was predominanly based on an assessmen of inflaion in erms of WPI. The macro-economic scenario in early 2000s was ha of an economy experiencing considerable slowdown in growh resuling from a combinaion of domesic and exernal facors. Even hough he economy saw wo years of deficien monsoons in close succession (2002 and 2004), overall food inflaion remained 8 Under he muliple indicaor approach, ineres raes or raes of reurn in differen markes along wih movemens in currency, credi, fiscal posiion, rade, capial flows, inflaion rae, exchange rae, refinancing and ransacions in foreign exchange available on a high frequency basis were juxaposed wih oupu daa for drawing policy perspecives. 4

8 benign. Coupled wih weakened demand condiions, overall inflaion, herefore, remained well inside he comfor zone. Moneary policy a he sar of he decade was expansionary o suppor he growh recovery, wih he key policy raes seeing a reducion by 300 basis poins during Wih growh firming up, underlying inflaion pressures sared o emerge in early 2005, promping a reversal of moneary policy sance o a ighening mode. As a resul of he implemenaion of he Fiscal Responsibiliy and Budge Managemen (FRBM) rules in 2004, fiscal defici of he cenral governmen which was a 4.3 per cen in was sequenially brough down o 2.5 per cen in and helped o conain he risk of expansionary fiscal policies engendering aggregae demand pressures. The seady capial inflows induced real appreciaion of he currency helped o moderae impored inflaionary pressures. Furhermore, even as commodiy prices sared o edge up since 2005 is immediae pass-hrough was mued on accoun of adminisered pricing of many producs, especially fuel 9. Though inflaion, on an average, was seady a 5-6 percen and in line wih policy objecives during his phase, by 2008 inflaion as measured by WPI breached single digis o a level much above he comfor zone of he Reserve Bank. CPI inflaion also regisered a sharp increase. A susained rise in global commodiy prices in general and especially ha of crude oil and is lagged pass-hrough o adminisered prices sho up fuel inflaion and hrough he inpu cos channel and second round effecs fed ino he underlying inflaion process. Furher, he economy was showing signs of over-heaing from growh raes in excess of 9 per cen for hree consecuive years. Aggregae demand pressures were furher accenuaed by unprecedened capial flow induced domesic surplus liquidiy condiions, which hen fueled high credi growh and asse price increases. This was happening even as he policy rae was raised by a cumulaive 300 basis poins o a peak of 9 per cen in However, policy raes in real erms, hough posiive, winessed a sharp fall. Moneary policy in his period was underaken in a challenging environmen of unprecedened capial inflows. Oher han ineres raes, a number of moneary policy insrumens were used o modulae domesic liquidiy and aggregae demand and mainain macro-sabiliy. The cash reserve raio (CRR) was increased sharply concomian wih rae hikes o mop up surplus domesic liquidiy and srenghen moneary ransmission. Ourigh serilizaion hrough marke sabilizaion scheme was also carried ou. Furhermore, 9 See Khundrakpam,(2008) 5

9 o modulae leverage and asse price inflaion, macro-prudenial measures in he form of higher risk weighs and provisioning norms were prescribed for bank lending. Phase II: Persisenly High Inflaion: In he immediae afermah of he Lehman Brohers collapse and he resuling conagion in global financial and commodiy markes, which snowballed ino he global financial crisis (GFC), GDP growh in India saw a sharp fall as in addiion o he sharp conracion in exernal demand, he freeze in foreign financial markes quickly ransmied o a emporary disrupion in shor-erm lending by banks, adversely impacing rade and domesic aciviy. However, as calm reurned o financial markes, by second half of 2009, growh saw a sharp rebound o ouch close o 9 per cen in 200- aided by boh expansionary fiscal policy and moneary easing. Hence, he large negaive oupu gap a he sar of 2009 urned posiive in abou wo quarers ime. Inflaion as measured by CPI and WPI iniially saw considerable divergence, primarily reflecing he larger share of radable primary commodiy in WPI, prices of which slumped immediaely in response o he GFC while CPI inflaion remained elevaed near double digis. A series of supply side commodiy price shocks, pushed WPI inflaion up from negaive erriory in early 2009 o around 0 per cen in 200 and inflaion process quickly became generalised. One of he proximae cause of he upurn was he monsoon shock of 2009 and he resulan rise in food inflaion. Food price pressures persised even afer he monsoon shocks faded away possibly reflecing he impac of governmen inervenions in agriculural produc and labour marke-such as sharp increase in Minimum Suppor prices (MSPs) and enhanced coverage under he Mahama Gandhi Naional Rural Employmen Guaranee Ac (MGNREGA). Along wih his, changes in food consumpion paern in response o rising incomes led o demand supply mismaches in specific food groups. This resuled in relaive prices of food o rise sharply during his period. In a scenario of rapidly increasing world oil prices, is pass-hrough, hough parially offse by adminisered price mechanism led o higher domesic prices. Consequenly, given he pos-crisis slowdown in poenial oupu, srong demand pressures along wih rising inpu coss, hrough wages and raw-maerial prices, quickly ransmied o oupu prices of goods and services leading o sharp increases in underlying inflaion. Furhermore, persisen food and fuel price shocks in a conex of low 6

10 moneary policy credibiliy led o drif in inflaion expecaions conribuing furher o overall inflaion persisence 0. Moneary policy during his period was characerized firs by a normalisaion from crisis driven expansionary policies and subsequenly o a series of calibraed ighening measures on concerns of inflaion persisence while mindful of being he durabiliy of he growh recovery. The moneary policy response a his ime was furher challenged by difficulies in assessing he sae of he economy boh due o he difficulies in assessing he exen of loss of poenial oupu and issues relaing o daa in a scenario of considerable uncerainy. Furhermore, he coninuaion of an expansionary fiscal sance righ up o in he mids of a srong pick-up in domesic demand added furher challenges. Subsequenly, enrenched inflaionary pressures led moneary policy o shif gears o aggressive ighening. However, on concerns of a sharp slowdown in he economy policy raes and signs of moderaion in inflaion, key policy raes were eased during 202 and he firs half of 203. The lack of a credible nominal anchor during his period, and he consequen de-anchoring of inflaion expecaions, has had deleerious impac on overall macroenvironmen. As documened in he Exper commiee repor, persisen and elevaed inflaion in he pos-crisis period led o an erosion of savings in view of negaive real ineres raes on bank deposis, loss of compeiiveness and worsening of rade defici, iner alia, on accoun of higher gold demand, which was used as a hedge agains rising inflaion. These macro vulnerabiliies led o several concerns on macro-financial sabiliy which manifesed in erms of he urmoil following he aper anrum in 203. Towards he laer par of 203 wih he availabiliy of all India CPI (Combined) - alhough wih a shor hisory- moneary policy communicaion began o be increasingly carried ou in erms of CPI han WPI. I was in his conex ha he need for a review of he moneary policy framework was fel and he Exper commiee was formed. Phase III: Disinflaion and a New Framework: 204 ill dae Following he recommendaions of he Exper commiee repor, he sar of 204 saw RBI endorsing he glide pah of CPI inflaion o reach 8 per cen by January 205 and 6 per cen by January 206 and moving owards a flexible inflaion argeing framework. Though CPI inflaion moderaed from double digi levels o single digis, i coninued o remain elevaed and persisen a he sar of 204, as he pass-hrough of exchange rae depreciaion following he aper anrum 0 A lis of sudies on inflaion process in his period include Para and Ray (200), Basu (20), Gokran (20), Darbha and Pael (202), Nadhanael (202), Para e al. (204), Gulai e al. (203), Sonna. e al. (204), Mohany and John (205), Bhaacharya and Gupa (205). 7

11 played ou hrough he economy even as aggregae demand sared o wane. To break he inflaion persisence, key policy raes were increased in January 204 furher reinforcing he earlier hikes in he second half of 203. By he second half of 204 underlying inflaion sared o ease on a more susained basis. This was furher aided by sharp fall in commodiy prices especially crude oil and he reurn of a relaively sable exchange rae. Furhermore, in spie of deficien monsoons, food inflaion moderaed owards he end of 204 on a combinaion of beer supply managemen policies, moderae increase in MSPs leading o a correcion in he relaive price of food, which had been rending sharply upwards pos As a resul, headline inflaion saw a rapid decline o 5.2 per cen in January 205, significanly undershooing he glide pah arge. Along wih i household inflaion expecaions moderaed somewha and expecaions on par of professional forecasers became beer anchored o he inflaion glide pah. Since January 205 inflaion condiions evolved generally in accordance wih he disinflaion glide pah reaching 5.7 per cen in January 206 (below he disinflaion arge of 6 per cen se for January 206). The move owards a flexible inflaion argeing framework was formalized hrough an agreemen beween he RBI and he governmen in February 205. As he economy remained wihin he pah of broad-based disinflaion, wih a view o suppor growh, in a scenario of renewed concerns on he srengh of recovery of global economy, he policy repo rae was reduced by 50 bps during January 205 o April 206.The Finance Ac 206 of May 206 amended he Reserve Bank of India Ac, 934 o sae price sabiliy as he primary objecive of he moneary policy, adopion of flexible inflaion argeing wih CPI as he nominal anchor for moneary policy along wih he seing up of a Moneary Policy Commiee (MPC) o se he policy rae o achieve he inflaion objecive (GoI, 206). The amended RBI Ac came ino effec in June 206. In Augus 206, he Governmen noified an inflaion arge of 4.0 per cen, wih 6.0 per cen and 2.0 per cen as he upper and lower olerance levels respecively, for he period up o March 3, 202. The Governmen and he Reserve Bank consiued he six member MPC in Sepember 206. The narraive of he key feaures of he inflaion process since 2000s poined o he lack of an explici nominal anchor as a key facor ha led underlying inflaion o drif upwards. In he absence of a nominal anchor, relaive price shocks o fuel as well as food quickly ranslaed ino a persisen generalized inflaionary process. The large role of food price shocks, especially, and energy price shocks, in shaping Indian inflaion dynamics underscores he need for a srong nominal anchor o anchor inflaion and inflaion expecaions. See Rajan R. (204), Anand e al. (204). 8

12 IV. Inernaional Experience wih IFT Ofen, he argumens agains IFT in counries such as India poin owards he predominan role of supply shocks in driving inflaion condiions. Inernaional experiences wih IFT in counries ha previously had weak price sabiliy hisory, however, sugges ha i may in fac help in reducing he ampliude of such shocks. The experiences of New Zealand, Canada, and he Czech Republic show ha all hree resored o inflaion argeing o deal wih an enrenched problem of high and variable inflaion (Clinon e al., 205; Figures 2-4). In Canada and New Zealand high inflaion originaed wih an inadequae framework for resising inflaion impulses from supply shocks in he 970s. Long-erm inflaion expecaions racheed up. Low levels of inflaion, and expecaions ha hese would coninue over he long run, were evenually achieved. Bu his was a he cos of subsanial loss of oupu and employmen during he ransiion o price sabiliy. Figure 2: New Zealand - Inflaion and Inflaion Expecaions 9

13 Figure 3: Canada - Inflaion and Inflaion Expecaions Figure 4: Czech Republic - Inflaion and Inflaion Expecaions 0

14 Figure 5: US - Inflaion and Inflaion Expecaions The experience in he Unied Saes is somewha differen, bu wih a similar oucome a he end (Figure 5). The US Federal Reserve (Fed) policy never having really broken down evolved gradually ino is curren regime, which looks a lo like FIT, alhough he Fed does no self-idenify as an inflaion argeer (Alichi e al., 205). The behavior of inflaion and inflaion expecaions over he las 3 decades has much in common wih ha in he 3 economies discussed above. By he urn of he cenury, mos cenral banks ha adoped FIT had also se up a forecas and policy analysis sysem (FPAS), o assis he implemenaion of flexible inflaion argeing in essence, as a core componen of he FIT archiecure. Calibraed moneary policy models played a cenral role. The overriding jusificaion for model calibraion as opposed o equaion-by-equaion saisical esimaion is ha models for useful policy analysis mus embody widely acceped heoreical principles, and yield empirically plausible predicions. Tradiionally esimaed economeric models may no exhibi desirable properies. Economeric esimaion also suffers from is sensiiviy o deficiencies in daa which made i a non-viable opion for counries like New Zealand and he Czech Republic. On a comparaive perspecive, he inflaion in India showed similar paern as ha in he FIT counries discussed above, excep in he 970s, a period which was plagued by oil shocks, droughs and war (Figure 6). There are sark similariies wih

15 he naure of problems ha counries like New Zealand, Canada, and he Czech Republic experienced a he ime hey adoped inflaion argeing wih ha faced by India during he years preceding he FIT. Ye, here are a number of challenges ha remain peculiar o India, some of which are deailed below. Figure 6: India - Inflaion and Inflaion Expecaions V. Challenges for Implemening FIT in India Transmission Mechanism Weaknesses Firs and foremos, i is imperaive o ake ino accoun he key India specific characerisics of he moneary policy ransmission mechanism. Moneary policy ransmission process is found o be having muliple channels wih ineres rae emerging as he mos imporan moneary policy ransmission channel 2. Bank lending channel was also seen o exis and complemen he ineres rae channel 3. Asse price and exchange rae channel of moneary policy ransmission, however, were found o be feeble in India 4. On he ineres rae ransmission channel, hisorically while he ransmission of policy raes o money markes and financial marke raes has been fairly 2 See RBI (2005), Mohan, R. (2008), Para and Kapur (200), Aleem (200), Bhaacharya e al. (20), Khundrakpam and Jain (202), Kapur and Behera (202), Mohany (202),Klezer ((202), RBI (204), Das (205). 3 See Pandi, e al. (2006), Bhaumik e al. (20), Bha and Kishor (203) 4 See Singh and Paanaik (202), Khundrakpam. (2007), Bhaacharya e al. (2008), Khundrakpam and Jain (202). 2

16 complee, he ransmission o medium erm bank lending raes was, however, sluggish (Figure 7). Figure 7: Trends in Key Ineres Raes per cen Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-0 Mar- Mar-2 Mar-3 Mar-4 Mar-5 Repo Rae Weighed Average Call Money Rae 3-monh T-bill Rae Base Rae Weighed Average Lending Rae (Ousanding Loans) All raes oher han Weighed Average Lending Rae (WALR) represens he average rae for he monh of March. WALR is compued as on March 3 s of each financial year. The Exper commiee highlighed a number of impedimens o he ransmission of policy rae o lending raes, wih adminisered ineres raes, sauory preempions, rigidiies in deposi rae srucure and lack of exernal benchmarks being he mos prominen. Adminisered ineres raes ake he form of ineres rae on small saving schemes which is adminisered by Governmen policy. Small saving ineres raes represens in one sense he floor for savings deposi raes and during phases of moneary easing, if ime deposi raes of banks fall below he adminisered small savings raes i could resul in a siuaion wherein he bank deposis migrae o small saving schemes in search of higher reurns. This could be alleviaed in fuure as governmen of India on February 6, 206 announced measures o align he small saving ineres raes wih he marke raes of he relevan Governmen securiies. Furhermore, a large par of deposis of banks are reail based and he fixed enure of deposis gives a rigidiy o he cos of funds srucure of banks. Creaion of floaing deposi rae producs also face he challenge of lack of a ransparen exernal money marke benchmark for pricing. High levels of sauory preempions ofen lead o crowding ou of credi and arificially suppress he long erm risk free ineres raes, impeding ransmission of policy raes o longer raes. Anoher facor ha has a significan bearing on he ransmission process is he impac of exogenous capial flows induced bous of volailiy in domesic liquidiy 3

17 condiions. In he face of overwhelming inflows, capial flows ha are lef unserilised has a considerable bearing on overall moneary and financial condiions, as was seen in he mid-2000s. A a much broader level, he recourse o informal finance by a considerable secion of he populaion, even as financial inclusion hrough insiuional sources have made remendous progress over he las decade, undermines he efficacy of moneary policy impulses in influencing aggregae demand. Impedimens o ransmission can also arise on accoun of he pricing srucure for loans followed by banks in India. This would come abou in he form of compuaion of Base Rae 5 based on average cos of funds by banks resuling in lending rae pricing o be less sensiive o changes in policy rae. Since April 206, he Reserve Bank has made i mandaory for all banks o arrive a he Base Rae using marginal cos of funds. Imporance of Food Prices o Changes in he CPI Food group consiues abou 46 per cen of he CPI baske in India and he high share of food in CPI poses a significan challenge in FIT implemenaion. Food prices are highly suscepible o supply shocks, which ofen manifes in India in he form of vagaries of rainfall and is impac on agriculural oupu. Also, he changes in he underlying srucure of he economy and shifs in composiion of demand could generae rends in relaive price of food which may lead o a secular divergence beween food and non-food inflaion (Figure 8). In such a scenario, he efficacy of FIT could be quesioned. Finally, here are a number of inervenions of he governmen in agriculural produc markes such as seing of minimum suppor prices and in labor markes in he form of employmen guaranees and minimum wages. 5 Base rae for loans by commercial banks refers o raes based on hose elemens of he lending raes ha are common across all caegories of borrowers, and as such i represens he floor for bank lending raes o which spread componens are added o arrive a he lending rae for a paricular borrower. 4

18 Index: 200= Figure 8: India: Relaive Price of Food* Apr/06 Oc/06 Apr/07 Oc/07 Apr/08 Oc/08 Apr/09 Oc/09 Apr/0 Oc/0 Apr/ Oc/ Apr/2 Oc/2 Apr/3 Oc/3 Apr/4 Oc/4 Apr/5 * Raio of Food Group Index o Overall CPI for Indusrial Workers In erms of he concepual framework, moneary policy affecs he rae of inflaion in he shor and medium erm hrough he effec of he oupu gap on nonfood non-fuel prices. This would be ypically incorporaed ino a macro model, wherein he Phillips curve operaes hrough he sicky prices of he core consumpion baske. The high weigh on food herefore dilues he medium-erm effec of policy rae changes on overall CPI inflaion. In addiion, he high variance of food prices inroduces noise ino he inflaion rae ha makes i difficul for he public and policymakers alike o perceive he influence of moneary policy. While recognizing he imporance of swings in food prices in condiioning he medium-erm flucuaions in he CPI and he hisorical dominance of he food componen in major cycles of inflaion in India, one should no use i as an argumen agains FIT. Raher, i underscores he major weakness in he erswhile policy regime: ha i did no provide a firm nominal anchor o buck he pass-hrough of food price shocks o generalized inflaion. Under a credible moneary policy regime wih sable long-run inflaion expecaions, he relaive price changes, which moneary policy is powerless o affec, could have aken place hrough one-off changes wihou exended pass-hrough effecs o he overall inflaion. In India, some lags in he adjusmen of prices o shocks is ineviable, especially in hose adminisered by he governmen. This, however, merely spreads ou he shock bu wih sable expecaions he effec of supply shocks on inflaion would be ransiory in a credible moneary policy regime. An esablished FIT program, herefore, provides an effecive sraegy for dealing wih he second round effecs of supply shocks. Firs, a credible long-run inflaion arge serves as an anchor o expecaions. Second, he cenral bank reinforces he anchor by publishing a forecas ha shows a medium-erm pah back o arge along wih is assessmen of he channels hrough which he inflaion 5

19 adjuss back o he arge aking ino accoun all he inrinsic lags in he adjusmen process. As he FIT gains credibiliy, and wins he public confidence in is abiliy o ensure price sabiliy even in an economy subjec o price level shocks, inflaion expecaions would remain aligned o he medium-erm arge, which in iself would ensure ha he effecs of supply shocks on inflaion remain ransiory. The srong relaive price rend, on he oher hand, creaes subsanive uncerainies, and become a communicaion problem. Trending relaive prices would raise quesions on he legiimacy of he use of core inflaion in policy formulaion as core inflaion may urn ou o be a sysemaically downward-biased indicaor of headline inflaion. The communicaion becomes challenging following a food price shock, as he auhoriies canno poin o core inflaion o reassure he public ha policy is on he righ rack when he arge i expressed is in erms of headline inflaion. The challenge o moneary policy communicaion during a period of rending relaive prices, herefore, lies in providing an assessmen of he likely size and duraion of he relaive price rend. No Track Record he Challenge of Building Credibiliy Before he inroducion of he FIT, he RBI did no have an explici price sabiliy mandae as is overarching objecive. Therefore, he public has no hisorical record from which i can judge he commimen of he RBI o he announced long-run inflaion arge, or wheher is acions o his end will prove effecive. Despie he regime change, he hisory of high and unsable inflaion doubless weighs heavily in he public mind. Credibiliy, herefore, can be esablished earned, over ime, by achieving announced objecives, and by effecive, ransparen communicaions. On he oher side, i can be los hrough policy acions inconsisen wih saed objecives. Expecaions may absorb or amplify an inflaion shock, he mechanism of which is illusraed in Figure 9. In he even of an inflaionary shock, even if he cenral bank raises he policy rae, he effec on he economy depends on how he public inerpres his acion. 6

20 Figure 9: Policy Credibiliy or Lack of Credibiliy Percepion of policy Inflaion expecaions Inflaion shock Policy rae Acive Anchored Shock Passive Shock Credibiliy resuls in shock absorpion. If he rae hike is perceived as he asserive response by a credible cenral bank, long-erm inflaion expecaions remain sable, and he policy acion raises he real rae. In addiion, uncovered ineres pariy implies a drop in he real price of foreign exchange: k f r + j = [ z z ] + { r k + j + µ + j= 0 + Where: r is domesic real ineres raes, z is real exchange rae and μ is shock o ineres raes. Wih he ighened moneary condiions, demand is reduced, a negaive oupu gap is opened, and inflaion reurns wihou unusual delay o he long-run arge. k j= 0 j } Lack of credibiliy can lead o shock amplificaion. If, however, he public perceives ha he cenral bank o be passive, expecaions of inflaion ( Eπ + ) could rise in a way such ha he change in he real rae ( r ) following he policy rae (i ) increase is difficul o ascerain. = i Eπ + r. In he wors siuaion, unanchored expecaions amplify he iniial impac of he shock, and propagae o yield a prolonged inflaion spiral. An observer migh hink ha policy rae increases are ineffecual in he figh agains inflaion, whereas he real problem is ha he policy acions are insufficienly aggressive given he shaky confidence in he abiliy o deliver on he price sabiliy objecive. 7

21 During he iniial years of adopion of FIT, he credibiliy evolves gradually, which helps in keeping he economy in beween he wo above discussed scenarios. I could also be possible ha credibiliy-building happens a a rae faser or slower han expeced, and such dynamics should be clearly accouned for while calibraing he models for policy simulaion. VI. Quarerly Projecion Model Having discussed he key challenges faced in implemenaion of FIT, we now urn o he core Quarerly Projecion Model (QPM) o illusrae is key properies and how some of hese issues are addressed wihin he overall srucure of QPM. Overview The foundaion for he QPM family of models is a forward-looking, 4-equaion, open-economy model for moneary policy. Endogenous variables are oupu gap, inflaion, ineres rae, and exchange rae. This se-up is a sandard modern day workhorse for forecasing and moneary policy analysis. Table liss he behavioral equaions of he core-qpm. This model omis secoral deails which are explained in deail in he producion-qpm 6, which encompasses more elaborae dynamics. I also conains a quadraic loss funcion, which embodies a more realisic view of policymaking under FIT han he linear reacion funcion in he producion model while small deviaions from desired oucomes may be olerable, very large deviaions can lead o dark corners (e.g. inflaion spirals or deflaion raps) ha should be avoided like he plague (Blanchard, 204). The oupu gap responds o he real ineres rae and he real exchange rae. The expecaions-augmened Phillips curve allows for a rade-off beween oupu and inflaion in he shor run, bu no in he long run. The exchange rae is deermined via an uncovered ineres pariy condiion ha allows for a risk premium. However, his is modified o reduce he sensiiviy of exchange raes o ineres rae differenials so as o capure fricions relevan o India (e.g., capial conrols and developing financial markes). A loss funcion penalizing deviaions of inflaion from he arge, oupu gaps, and ineres rae variabiliy deermines moneary policy and hence he ineres rae. Expecaions are a combinaion of model-consisen (i.e., raional) and backward-looking componens. 6 See Benes e al. (206) 8

22 Oupu gap Inflaion Table : Ouline of Core-QPM Equaions yˆ α α ˆ ˆ ˆ + ε m = E[ y+ ] + α 2 y α3r + α 4zˆ = 0.07; α 2 = 0.60; α3 = 0.08; α 4 = yˆ π β3 yˆ = βe[ π 4+ ] + ( β) π + β 2 ( e ) / β 3 + β 4 zˆ + β = 0.33; β2 = 0.06; β3 = 0.4; β4 = Moneary policy loss funcion ε π L = i= 0 i β [ λ ( π π ) λ yˆ λ ( i * i i i + i ] β = 0.98; λ = ; λ2 = ; λ3 = Uncovered ineres pariy wih risk premium E S 0.5. f S i = i + σ + ( ES+ S ) 4 + ε f + = δ S+ + ( δ) { S + 2 / 4 [ Z + ( π 4 π 4 )] + δ zˆ } 2 δ = 0.6; δ 2 = 0.3. Uncovered ineres pariy wih risk premium and delayed exchange rae adjusmen bu wihou long-run PPP f S γ i ( i + σ )] = ( E S + S ) 4 + ε, 0 < γ [ < Uncovered ineres pariy wih risk premium and delayed exchange rae adjusmen and long-run PPP i ). γ i i σ γ Z π π E S S + ε f f [ ( + )] + ( ) [ 4 + ( 4 4 )] = ( + ) 4 γ = 0.7. S Inflaion expecaions wih credibiliy bias 5 i π π E[ π 4+ ] = c π ( c ) π 4 + b ( c ) + κ [ c ] ε i+ i= π b = 0.25; κ =. Noaions: oupu gap (yy ) real ineres rae gap (rr mm ), he real exchange rae gap (zz ), shocks o aggregae demand (εε yy ), domesic prices (PP ) foreign price (PP ff )inflaion - annualized quarerly changes in he seasonally adjused logarihm of CPI(ππ ), inflaion expecaion(ee [ππ4 + ]), shocks o inflaion (εε ππ ), Ineres rae ((ii ) exchange rae (SS ), expeced exchange rae(ee SS + ), foreign nominal ineres rae (ii ff ), ime-varying counry 9

23 risk premium (σσ ) change in real exchange rae rend ( ZZ )year-on-year inflaion(ππ4 )foreign inflaion (ππ4 ff ), shocks o exchange rae (εε SS ), credibiliy sock (cc ). Noe: The calibraions of he coefficiens are based on QPM producion paper. For deails see Benes, e al. (206). Figure 0 illusraes how he FIT works. A crucial aspec of his is he feedback o he shor-erm ineres rae (policy rae), which is he insrumen of moneary policy (he feedback is depiced by dashed red lines in he char). Figure 0: Moneary Policy Model: FIT Feedback Response and Transmission Insrumens Objecives The policy ineres rae is endogenous consisen wih he nominal anchor o he sysem implying ha he ineres rae has o follow a pah consisen wih he long-run inflaion arge. For any iniial deviaion from arge, however, here are many alernae ineres rae pahs ha would bring inflaion back on rack over he medium erm: for example, large early rae changes may ge inflaion on arge quickly, bu wih a subsanial adverse impac on oupu; more gradual policy acions will achieve he arge more slowly, bu wih less adverse impac on oupu. Using his framework, alernae ineres rae pahs could be generaed, which are consisen wih inflaion arge, based on policy makers assessmens of underlying macroeconomic siuaion. 20

24 Some Specific Feaures of Core-QPM 3yˆ The Phillips curve conains a non-linear oupu gap. The erm ( e β ) implies an increasing marginal effec on he inflaion rae as he gap increases. A wide negaive oupu gaps, he curve becomes quie fla (Figure 0). Figure0: Convex Phillips Curve Phillips curve becomes seeper. Phillips curve becomes very fla. Excess supply Excess demand In view of he newness of he FIT regime, we assume ha i akes ime o esablish is credibiliy. Thus expecaions formaion includes a credibiliy building process (Table 2). The cenral bank adds o is credibiliy sock by demonsraing ha i is achieving he policy goal. There are 2 ypes of expecaion building processes. The firs ype is opimisic ye wachful: i aaches a posiive weigh (c ) o he cenral bank s inermediae arge for inflaion (i.e., he cenral bank s own forecas), bu also some weigh (-c ) o acual observed inflaion. A good signal for credibiliy, reinforcing opimism, is when inflaion falls owards he long-run arge more quickly han he cenral bank forecas. The second ype, condiioned by hisory, is skepical. I pus some weigh on he high levels of he pas 7, as well as 7 we assume 8 percen 2

25 on acual inflaion, bu ignores he cenral bank forecas. A bad signal is when inflaion is above he rae expeced by he skepics. Table 2: Endogenous Credibiliy Process Expecaions formaion E [ π 4 ] = c π 4 + ( c ) π 4 Credibiliy sock building + + b π + 4 ( c 5 ) + κ i= i π [ c ] ε i+ c c c = ρ c + ( ρ ) ξ Signal for revision of credibiliy based on squared forecas errors H 2 ( ε ) ξ = H 2 L ( ε ) + ( ε ) 2 Good signal inflaion lower han expeced by opimiss L ε = * π 4 [ ρ π 4 + ( ρ) π ] Bad signal inflaion higher han expeced by skepics ε H = π 4 [ ρ π 4 + ( ρ) π H ] H ρ = 0.5; π = 8; π * = 4. Boundary condiions If ππ4 [ρρ ππ4 + ( ρρ) ππ ] < 0, henξ =. If ππ4 [ρρ ππ4 + ( ρρ) ππ HH ] > 0, hen ξ = 0. See Alichi e al. (2009) for deails. Noaions: inflaion expecaion (EE [ππ4 + ]), year-on-year inflaion (ππ4 ), credibiliy sock (cc ). signal (ξξ ), inflaion arge (ππ ) Moneary policy minimizes a quadraic loss-funcion, which penalizes squared deviaions from oupu and inflaion objecives and large shor-run ineres rae changes. I is common o use a linear (Taylor-ype) rule o characerize moneary policy under inflaion argeing. Such an approach may be adequae for normal siuaions, which are no near dark corners in oher words, deflaion or high inflaion raps. For India he relevan dark corner could be a siuaion in which expecaions of high inflaion become so enrenched ha heir eliminaion would require huge coss in los oupu and employmen. Moneary policy 22

26 would need o pu an increasing marginal cos on deviaions from arge as hey grow. Policymakers avoid sharp ineres rae changes. The penaly in he loss funcion for seep policy rae changes reflecs he well-known preference of policymakers for gradual rae movemens. This has he economic raionale ha policymakers uncerain abou he source or he duraion of a shock will proceed cauiously. In addiion, more variable changes in raes are liable o convey less informaion o he public abou he sance of moneary policy. A given policy rae change has more effec on longer-erm ineres raes and he exchange rae, if here is less noise in is movemens. VII. Illusraive Core-QPM Moneary Policy Experimens The mos imporan funcion of a QPM ype of model is o be a ool for policy maker o assess he implicaions of alernae policy opions under periods of uncerainy. We race ou a few plausible scenarios in he Indian conex so as o illusrae he policy opions and heir likely implicaions using he QPM. Disinflaion This experimen derives pahs for endogenous variables in a disinflaion goal ha would ake inflaion from 5 percen o 4 percen. Minimizing he loss funcion ensures ha he laer is achieved a he lowes cos in erms of loss in oupu and ineres rae variabiliy. We assume an iniial equilibrium wih 5 percen inflaion, and hence a nominal ineres rae of 7 percen (or a real rae of 2 percen). Wih iniial credibiliy no very high, he cenral bank has o hike he policy rae in he baseline (Figure ). The uncovered ineres pariy condiion warrans a drop in he exchange rae (i.e. appreciaion of he rupee), under no furher shocks o he sysem. The combinaion of ineres rae increase and exchange rae appreciaion reduces demand, and opens a negaive oupu gap. Inflaion declines firs by he impac of he sronger rupee, and hen, increasingly over ime, by he negaive oupu gap. The cos in erms of cumulaive forgone oupu is 2 percen of annual GDP (i.e. sacrifice raio of 2). Hawkish policymakers would achieve he long-run arge slighly faser han he baseline. Bu hey would raise he policy rae more, riggering a sharper appreciaion, a wider medium-erm negaive oupu gap, and hence a larger sacrifice raio. Dovish policymakers, in urn, wih a higher weigh on he oupu gap, would ighen moneary condiions less han baseline and hence he sacrifice raio will be lower. 23

27 Figure : Leas-cos Disinflaion--Endogenous Credibiliy Noe: X-axis represens quarers; he same applies for he subsequen chars Figure 2 shows a pah generaed under he assumpion ha he policy sance is fully credible. The -percen reducion in inflaion is achieved wihin a 6 quarer ime horizon, a lower cos of los cumulaive oupu one-half percen of annual GDP. In he baseline, he ighening of policy is achieved wihou any increase in he policy ineres rae in effec, he required increase in he real rae is achieved enirely hrough he reduced expecaions of inflaion. In he case where policymakers place more weigh on deviaions of oupu from long-run equilibrium, he more gradual approach furher reduces he oupu cos. Where policymakers exhibi willingness o olerae shor-erm loss of oupu and employmen and accordingly place less weigh on he oupu gap, here is a small policy rae increase, and a slighly higher sacrifice raio. Bu clearly, policymakers preference on he 24

28 oupu gap makes lile maerial difference o oucomes in he prefec credibiliy siuaion. Figure 2: Leas Cos Disinflaion Perfec Credibiliy Miigaing Demand Shocks he Divine Coincidence Under opimal policy, he cenral bank raises (cus) he policy rae o deal wih posiive (negaive) demand shocks (Figure 3). Dealing wih such shocks does no creae a conflic beween oupu and inflaion objecives he divine coincidence (Blanchard and Gali, 2007). Wih he promp, acive response o he shock, inflaion is held close o baseline in each case. Given he fla Phillips curve under excess supply condiions, he widening of he oupu gap has o be somewha greaer for he negaive han for he posiive shock. Because inflaion is well conrolled, he demand shocks have no major impac on credibiliy. 25

29 Figure 3: Demand Shocks Miigaing Supply Shocks Trade-offs A nasy supply shock requires an increase in ineres raes and a larger negaive oupu gap (relaive o baseline) o mainain he pah o he 4 percen longrun arge (Figure 4). The medium-erm rade-off is beween he speed of he approach o he arge, and he size of he oupu gap. A promp and aggressive approach prevens long-erm inflaion expecaions from racheing upwards, and preserves credibiliy, bu has higher coss in erms of shor-run oupu. By conras, a favorable supply shock presens an aracive rade-off: inflaion moderaes relaive o baseline, and reaches 4 percen sooner; moneary policy eases; and oupu gap closes faser. 26

30 Figure 4: Nasy and Favorable Supply Shocks The policy conflic can be seen more sarkly in he conex of repeaed supply shocks (Figure 5). A sequence of nasy supply shocks requires a more aggressive ighening in moneary condiions, and a seep widening of he oupu gap. Even so, in he medium erm inflaion increases considerably he shor-run policy rade-off ( sagflaion ) looks bad. Moneary policy credibiliy akes a hi. Policy would, however, be successful in prevening long-erm inflaion expecaions from racheing up even wih bad luck, a commied cenral bank can sill successfully anchor longerm inflaion expecaions. 27

31 Figure 5: Sequence of Nasy Supply Shocks Imporance of Promp Acion versus Delay in Policy Response In he previous experimens promp effecive acion helped reduce he losses o oupu and moneary policy credibiliy following supply shocks. The imporance of imely policy acion can be shown wih an experimen in which policymakers wai before responding o a big nasy supply shock. If he policy acion is delayed he ineres rae hike has o be much greaer han under a baseline response, and he cumulaive oupu gap is larger, albei wih higher inflaion (Figure 6). Thus a delay in policy response causes a subsanial deerioraion in he medium-erm oupuinflaion rade-off. 28

32 Figure 6: Delay of Policy Response Imporance of Credibiliy Even when policy is perfecly credible, a sequence of nasy shocks poses a dilemma and he longer he sequence he greaer could be he deerioraion in he policy rade-off. In he medium erm, he ineres rae goes up, a negaive oupu gap widens, bu inflaion rises (Figure 7). There is a loss of policy credibiliy. Policy does succeed evenually in geing inflaion back on arge, and resoring repuaion, bu he coss in erms of los oupu are subsanial. 29

33 Figure 7: Sequence of Nasy Shocks Perfec Credibiliy The credibiliy facor may no fully eliminae he coss of dealing wih supply shocks, bu i does allow policymaker some leeway in erms of iming. Figure 8 compares promp acion wih delayed acion under perfec credibiliy which indicaes ha delay does lile damage. However, repeaed delays could, undermine he credibiliy. 30

34 Figure 8: Delay of Policy Response Perfec Credibiliy VIII. Conclusion This paper aemps o provide a broad overview of he analyical underpinnings of FIT implemenaion. Hisorical experiences of counries which have adoped inflaion argeing have shown ha having a credible policy wih an emphasis on srong nominal anchor can reduce he impac of supply shocks o inflaion and improve macroeconomic sabiliy. The core-qpm oulined in he paper races ou he India specific feaures and provides a flavor of how a QPM can be useful in FIT implemenaion. Illusraive experimens highligh he challenges confroning moneary policy under differen ypes of uncerainy and show ha if credibiliy is earned and preserved, moneary policy efficacy improves subsanially. 3

35 References Aleem, A. (200), Transmission Mechanism of Moneary Policy in India, Journal of Asian Economics, 2, Alichi, A., H. Chen, K. Clinon, C. Freedman, M. Johnson, O. Kamenik, T. Kışınbay, and D. Laxon (2009), Inflaion Targeing Under Imperfec Policy Credibiliy, IMF Working Paper 09/94. Alichi, A., Clinon, K., Freedman, C., Kamenik, O., Juillard, M., Laxon, D., Turunen, J. and Wang, H. (205), Avoiding Dark Corners: A Robus Moneary Policy Framework for he Unied Saes, IMF Working Paper 5/34. Anand, R., D. Ding, and V. Tulin (204), Food Inflaion in India: The Role for Moneary Policy, IMF Working Paper 4/78. Basu, K.(20), Undersanding Inflaion and Conrolling I, Economic and Poliical Weekly, Vol.46, No.4, Oc 8-4, Benes e al.(206), Quarerly Projecion Model for India: Key Elemens and Properies, Reserve Bank of India Working Paper WPS 08/206. Bha, V. and K. N. K. Kishor (203), Bank Lending Channel in India: Evidence from Sae-Level Analysis, Empirical Economics, Vol. 45, No.3. Bhaacharya, R., I. Panaik, and A. Shah (2008), Exchange Rae Pass-hrough in India, Macro/Finance Group a NIPFP,[Online]. Available a: hp:// macrofinance. nipfp. org. in/pdf/bps2008_erp. pdf. Bhaacharya, R., I. Panaik and A. Shah (20), Moneary Policy Transmission in an Emerging Marke Seing, IMF Working Paper /5. Bhaacharya, R. and A. S. Gupa (205), Food Inflaion in India: Causes and Consequences, NIPFP Working Paper No , June Bhaumik, S. K.,V. Dang, and A. M. Kuan (20), Implicaions of Bank Ownership for he Credi Channel of Moneary Policy Transmission: Evidence from India, Journal of Banking & Finance, Vol. 35, No. 9, pp Blanchard, O., and J. Gali (2007), Real Wage Rigidiies and he New Keynesian Model, Journal of Money, Credi, and Banking, Vol. 39, No., Supplemen, pp Blanchard, O.(204), Where Danger Lurks, Finance & Developmen, Vol. 5, No. 3, Sepember. Clinon, K., Freedman, C., Juillard, M., Kamenik, O., Laxon, M. D., & Wang, H.(205), Inflaion-Forecas Targeing: Applying he Principle of Transparency, IMF Working Paper 5/32. Darbha, G. and U. R. Pael (202), Dynamics of Inflaion Herding : Decoding India's Inflaionary Process, Working Paper 48, Global Economy and Developmen, Brookings. 32