Monetary Policy and Inflation Targeting

Transcription

1 MINISTRY OF FINANCE GOVERNMENT OF INDIA Monetary Policy and Inflation Targeting Module 4 Contemporary Themes in India s Economic Development and the Economic Survey. Arvind Subramanian Chief Economic Adviser Government of India 1

2 Overview Objective of Monetary Policy Monetary Policy Transmission Monetary Policy Framework Rationale How it works 2

3 Part I Objective of Monetary Policy 3

4 Objective of Monetary Policy Keep inflation and inflation expectations low and stable Help stabilize economy, including avoiding and responding to financial crisis 4

5 Objective of Monetary Policy why are price and economic stability important? High inflation creates uncertainty, reduces investment and reduces economy s supply potential Inflation adversely affects income distribution Inflation is a tax on poor Iron Law of Indian political-economy Inflation more than 5% counterproductive 5

6 per cent Objective of Monetary Policy Indian CPI inflation

7 Objective of Monetary Policy Economy overheating Potential Economy Economy below potential 7

8 Objective of Monetary Policy Avoid deflation (great depression) Avoid stagflation (low GDP but high inflation; post- oil crisis) Stabilize economy and financial system (global financial crisis 2008) US CPI Inflation (annual percentage change, blue line) and recessions (vertical shades) 8

9 Part II Transmission of Monetary Policy 9

10 Apr. 21, 2017 Mar. 3, 2017 Jan. 13, 2017 Nov. 25, 2016 Oct. 7, 2016 Aug. 19, 2016 Jul. 1, 2016 May 13, 2016 Mar. 25, 2016 Jan. 22, 2016 Dec. 4, 2015 Oct. 16, 2015 Aug. 28, 2015 Jul. 10, 2015 May 22, 2015 Mar. 27, 2015 Feb. 6, 2015 Dec. 19, 2014 Oct. 31, 2014 Sep. 12, 2014 Jul. 25, 2014 Jun. 6, 2014 Apr. 18, 2014 Feb. 28, 2014 Jan. 10, 2014 Nov. 22, 2013 Oct. 4, 2013 Aug. 16, 2013 Jun. 21, 2013 May 3, 2013 Mar. 15, 2013 Jan. 25, 2013 Dec. 7, 2012 Oct. 19, 2012 Aug. 31, 2012 Jul. 6, 2012 May 18, 2012 Mar. 30, 2012 Feb. 10, 2012 Dec. 23, 2011 Monetary Policy Transmission 1: Interest Rate and Borrowing Channel Policy Repo Rate Base Rate Mean Term Deposit Rate Mean Policy rate lending rate borrowing 10

11 Apr. 21, 2017 Mar. 10, 2017 Jan. 27, 2017 Dec. 16, 2016 Nov. 4, 2016 Sep. 23, 2016 Aug. 12, 2016 Jul. 1, 2016 May 20, 2016 Apr. 8, 2016 Feb. 19, 2016 Jan. 1, 2016 Nov. 20, 2015 Oct. 9, 2015 Aug. 28, 2015 Jul. 17, 2015 Jun. 5, 2015 Apr. 24, 2015 Mar. 6, 2015 Jan. 23, 2015 Dec. 12, 2014 Oct. 31, 2014 Sep. 19, 2014 Aug. 8, 2014 Jun. 27, 2014 May 16, 2014 Apr. 4, 2014 Feb. 21, 2014 Jan. 10, 2014 Nov. 29, 2013 Oct. 18, 2013 Sep. 6, 2013 Jul. 26, 2013 Jun. 7, 2013 Apr. 26, 2013 Mar. 15, 2013 Feb. 1, 2013 Dec. 21, 2012 Nov. 9, 2012 Sep. 28, 2012 Aug. 17, 2012 Jun. 29, 2012 May 18, 2012 Apr. 6, 2012 Feb. 24, 2012 Jan. 13, 2012 Dec. 2, 2011 Monetary Policy Transmission 1A: Interest Rate and Borrowing Channel, Transmission of Recent Rate Cuts Impeded by Rising NPAs Policy Repo Rate Base Rate Mean Term Deposit Rate Mean

12 Nov. 11, 2011 Jan. 13, 2012 Mar. 16, 2012 May 18, 2012 Jul. 27, 2012 Sep. 28, 2012 Nov. 30, 2012 Feb. 1, 2013 Apr. 5, 2013 Jun. 7, 2013 Aug. 16, 2013 Oct. 18, 2013 Dec. 20, 2013 Feb. 21, 2014 Apr. 25, 2014 Jun. 27, 2014 Aug. 29, 2014 Oct. 31, 2014 Jan. 2, 2015 Mar. 6, 2015 May 15, 2015 Jul. 17, 2015 Sep. 18, 2015 Nov. 20, 2015 Jan. 22, 2016 Apr. 8, 2016 Jun. 10, 2016 Aug. 12, 2016 Oct. 14, 2016 Dec. 16, 2016 Feb. 17, 2017 Apr. 21, 2017 Monetary Policy Transmission 2: Exchange Rate Channel $/Rs Repo (RHS) Policy rate capital inflow weaker local currency (depreciation) 12

13 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar Monetary Policy Transmission 3: Financial Savings Channel Real Deposit growth (RHS) Real interest rate based on average inflation of CPI and WPI Policy Rate in deposits rate Financial Savings 13

14 Part III Monetary Policy Framework 14

15 India s Monetary Policy Framework India has recently shifted to an inflation targeting framework Standard framework used by advanced country central banks What is inflation targeting (IT) all about? 15

16 History of Inflation Forecast Targeting Break of Bretton-Woods system in the 1970s world moved from fixed to floating regimes need for a new nominal anchor Unsuccessful alternatives to IT Money targeting? Exchange rate? IT developed pragmatically money demand too unstable! increasing capital mobility, speculative attacks Disinflation: Canada and New Zealand failed with money targeting in 1980s, Chile with exchange-rate-based stabilization policies End of pegs: U.K., Sweden (1993), Czech Rep. (1997), Brazil (1999) 16

17 Understanding IT Three key elements Objective: inflation target Supporting framework: institutional arrangements Decision rule: central bank reaction function 17

18 Empirical Evidence on IT OECD: No significant effect on inflation average and variability EMEs: Lower average inflation and, typically, inflation variability. Inflation in IT-countries has come down from a higher level 18

19 Three questions Why an inflation target? What institutional arrangements? What decision rule? 19

20 Three questions Why an inflation target? What institutional arrangements? What decision rule? 20

21 Many potential objectives Ensure stable prices Promote growth Maintain exchange rate peg Preserve financial stability Contain current account deficit 21

22 First Answer Price stability is very important 22

23 Second Answer India s historical experience Question: why an inflation target now, two decades after IT became popular in the rest of the world? Answer: until recently, no pressing reason to change the framework. RBI had kept inflation low, close to world norms But after the Global Financial Crisis, world inflation collapsed, while Indian inflation soared 23

24 Historical Inflation: India and Others Inflation Differential: India and low/middle income (LMI) countries Inflation in India higher than LMI countries Inflation in India lower than LMI countries -8 24

25 Five years of double-digit inflation Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Inflation Repo Rate 25

26 IT is a promise IT is a commitment by the government and RBI that they will never allow this to happen again To show their seriousness, they have formalised the commitment in a law But why only a inflation target? What about the other objectives? 26

27 Third answer Targeting multiple objectives is problematic RBI previously followed a multiple objectives regime; that s how inflation control was lost Tinbergen rule: for every objective, you need an instrument Central banks only have one main instrument interest rates! Which means they can really aim at only one objective 27

28 What about other objectives? Central banks still care about: growth exchange rate financial stability How do central banks deal with these objectives under IT? 28

29 Growth objectives Growth concern: if interest rates are too high, they could kill the economy But how can the RBI chase two targets without violating Tinbergen Rule? 29

30 A Miracle! 30

31 Divine coincidence Equilibrium equation: aggregate demand (planned expenditure, PE) = aggregate supply (Y) If PE < Y, that means output is likely to slump and inflation will be too low cut rates, cure both! If PE > Y, the economy is overheating and inflation will be too high raise rates, cure both! Miracle: aiming for an inflation target means stabilizing economic growth 31

32 Caution: miracles not guaranteed! Assumed supply is fixed But what if there is a supply shock? Favourable (fall in oil/food price) Best of both worlds: inflation falls and growth rises Unfavourable (rise in oil/food price, possibly GST) Stagflation: inflation rises and growth falls conflict! 32

33 Dealing with supply shocks Priority is given to controlling inflation Cannot control the first round impact on price level Focus on making sure first round increase doesn t trigger many subsequent rounds (embedded inflation) 33

34 Exchange rate objectives Exchange rate is more problematic Maintaining competitiveness is important But central banks face trilemma. Cannot have all three: Independent monetary policy (inflation target) Exchange rate target Free flow of capital 34

35 The Impossible Trilemma Only two of the three are possible Perfect capital mobility; Fixed/managed exchange rate; and Independent monetary policy (IMP) 35

36 The Impossible Trilemma Perfect Capital Mobility The Impossible Trinity Independent Monetary Policy China Fixed Exchange Rate 36

37 Jan-07 Aug-07 Mar-08 Oct-08 May-09 Dec-09 Jul-10 Feb-11 Sep-11 Apr-12 Nov-12 Jun-13 Jan-14 Aug-14 Mar-15 Oct-15 Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 Jan-11 Sep-11 May-12 Jan-13 Sep-13 May-14 Jan-15 Sep-15 Impossible Trilemma Case I Fixed/Managed ER IMP Restrictions on K-mobility CNY/USD Spread b/w China and US interest rate

38 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Impossible Trilemma Case II Fixed/Managed ER Perfect K-mobility MP independence lost Repo Rate Fed Rate Inflation (RHS) Rs./US$

39 Impossible Trilemma Case III IMP Perfect K-mobility Flexible ER CPI SELIC (RHS) NEER 39

40 Possible strategies Capital controls: allow exchange rate targeting, but tight controls will cut off inflows needed for growth FX intervention: can limit exchange rate appreciation, but will inflate money supply; excessive intervention will jeopardise inflation target Divine coincidence : appreciation reduces inflation, allowing interest rates to be cut; alleviates but rarely solves problem No central bank has found a perfect solution. RBI relies on a mix of above. 40

41 Institutional Biases on Interest Rates and Exchange Rates Group Preference Reasons Manufacturers Low interest rates, weak currency Profits increase, even if some inputs are imported, since market share grows. This applies both to exporters (clothing) and to firms producing for domestic market but competing with imports(steel, aluminium) Domestically oriented firms Low interest rates Profits increase; debt burden declines Infrastructure companies Strong currency Typically borrow in dollars, earn in rupees. Strong currency contains debt service burden without affecting revenues. Care less about domestic interest rates Households High interest rates Greater return on savings. Household saving far outweighs household borrowing. Equity investors -- Domestic Low interest rates Corporate profits increase, and hence returns. Equity investors -- Foreign Low interest rates, strong currency Combination boosts dollar returns. Tension: low rates typically lead to weaker currency. Bond investors -- Domestic Falling interest rates Generates capital gains. Banks prefer low rates; other investors (LIC) prefer high rates. Bond investors -- Foreign High but falling interest rates, strong currency Combination maximizes dollar returns. Tension: falling rates weaken currency. Government Low interest rates Low rates reduce debt service. Extra growth or inflation increases revenues. 41

42 Financial stability objectives Financial stability clearly important (see: Global Financial Crisis) Most central banks use prudential/regulatory measures to ensure stability Others argue that monetary policy should also be used, to reinforce prudential measures Increase rates if banks are lending excessively Reduce rates if banking system is under stress 42

43 Bottom Line IT means central bank has an inflation target Does not mean that inflation is the only objective Means that inflation is the primary objective Others can be pursued, but inflation takes precedence if a conflict arises 43

44 Operationalising the Target Once IT regime is agreed, must decide: particular measure of inflation to target specific level of inflation target 44

45 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 What Inflation Target? CPI Headline CPI Core

46 Virtues of CPI CPI Headline or CPI Core? CPI Headline includes oil and food prices whose prices cannot be controlled by the RBI CPI Core basket is 47.3% of the overall CPI basket RBI can only influence CPI core basket prices If so, why all central banks target CPI Headline? CPI headline reflects the prices consumers and savers face Easier to communicate Inflation expectations are based on headline CPI inflation 46

47 What level advanced countries target? Initially, IT central banks took price stability objective literally Targeted inflation no more than 2 percent Since Global Financial Crisis, emphasis on symmetry Tried to keep inflation near 2 percent, stimulate if too low Some have argued for higher target of around 4 percent, to allow highly negative real rates in case of severe recessions 47

48 What level target/emerging markets? Many EM s have targetted inflation around 4 percent, India: 2-6 percent Reasons EM s have more bottlenecks, difficult to target very low inflation target would keep nominal exchange rate stable Maths Assume EM productivity growth is 2 percentage points higher than AEs, Then EM wage/price growth can be 2 percentage point higher without loss of competitiveness So no need for nominal rate to depreciate 48

49 Three Questions Why an inflation target? What institutional arrangements? What decision rule? 49

50 Credibility Credibility is critical for central banks If the public doesn t believe the central bank is committed to an inflation target, interest rates will need to be kept high to prove intent To reinforce credibility, IT central banks institutionalize their commitment to low inflation 50

51 Monetary Policy Committee IT central banks have monetary policy committees (MPC) Purpose: to decide on monetary policy Reasons: Better decision-making, as members bring outside views Better credibility, when decisions endorsed by experts India s MPC: 3 from RBI, including Governor 3 external members, appointed by government Governor has casting vote 51

52 Accountability Government will hold RBI accountable for achieving inflation target Any deviation for three consecutive quarters will have to be explained In case of a failure, RBI will have to: Specify the reasons Suggest remedial actions Estimate the time period within which the target will be achieved 52

53 Transparency To enhance credibility, RBI explains its actions to the public: Press conference Interviews Inflation report Speeches 53

54 Independence Independence is critical Government has set the policy assigned inflation target to RBI RBI needs operational independence so it can achieve target 54

55 Operational Independence RBI must be free to choose appropriate interest rate Equally important: RBI must seen to be free Otherwise, decisions are seen as politically motivated Credibility is damaged, undermining entire exercise 55

56 Three questions Why an inflation target? What institutional arrangements? What decision rule? 56

57 Quiz! Let s say that the inflation target is a point target of 4 percent What should the RBI do if inflation rises to 7 percent? What should it do if inflation falls to 2 percent? 57

58 Wrong! 58

59 Reason 59

60 The Importance of Lags Monetary policy cannot control aggregate demand instantaneously Effects take about 1 to 2 years Implication: monetary policy must be forward looking 60

61 Looking Forward Good monetary policy requires sophisticated, model-based inflation forecast To assess likely path of inflation Appropriate interest rate path To guide expectations, most central banks (including RBI) publish their inflation forecasts Some also publish expected interest rate path 61

62 Judgement But economic models aren t perfect; future difficult to predict Setting monetary policy still requires judgement Monetary Policy Committee can help But expect the unexpected: inflation will deviate from target 62

63 Correcting Deviations Example: Target: 4 percent Actual: 7 percent Question: when should inflation return to target Problem 1: try to return to target too soon, high interest rates will kill economy Problem 2: adopt gradual approach, high inflation will become entrenched, and require very high interest rates to eradicate 63

64 Inflation Forecast Targeting Central banks cannot and should not attempt to always achieve inflation target Instead, they should target their inflation forecast Meaning: set policy in way that target is expected to be achieved over 2 year policy horizon Better name: inflation forecast targeting (IFT) 64

65 Possible Evolution in Inflation Targeting Nominal GDP Target Forward Guidance Olivier Blanchard Solution 65

66 Answers Why an inflation target? Maintaining price stability is the fundamental objective of central bank Other objectives can be pursued, as long as they don t pose a conflict What institutional arrangements? Monetary Policy Committees Accountability Transparency Operational independence What policy strategies? Forward looking, Policymaking is difficult, requires careful assessment and judgement 66

67 Recommended Readings Urjit Patel Committee Report 67

68 Thank You 68