by Thomas Richardson
The publication of the Urjit Patel Committee report on India's monetary policy framework, in January, elicited a lot of debate among policy economists about the appropriateness and feasibility of inflation targeting - even the flexible sort proposed by Patel et al. - in a developing economy like India. A good deal of the commentary has taken the negative view, arguing that India is not ready for inflation targeting, either because its macroeconomic data is too unreliable, or the role of food in headline inflation is too high, or the monetary transmission mechanism is too poorly understood, or because the real source of inflation lies with administrative policies driving rural wage growth.
These are all valid points, made by sensible, respected economists with a broad view of Indian economic reality. Nevertheless the RBI seems to be moving forward toward some form of the Patel Committee recommendations. Recent Monetary Policy Statements have hewn fairly closely to the committee's recommendations. Is the RBI heading in the wrong direction?
I think not, based in part on my experience working in Africa. Before joining the IMF's New Delhi office, I led the Fund's work in Uganda at a time when many countries in sub-Saharan Africa were reexamining their monetary policy frameworks. The discussion on whether or not inflation targeting is appropriate and feasible for India reminds me strongly of similar debates in Africa. In Africa, as in India, many analysts questioned whether inflation targeting is appropriate, arguing that macroeconomic data are too poor, there is too much food in the headline CPI basket, the transmission mechanism is weakly understood, or that administrative prices are the dominant factor. Sound familiar?
The evolution of the setting for monetary policy in Africa
For many years, countries in sub-Saharan Africa - frankly, like those elsewhere in the developing world - relied on controlling the money supply to achieve their inflation objectives. (Unless, that is, they maintain a pegged exchange rate, in which case their scope for independent monetary policy was very limited.) In recent years, however, central bankers in a number of developing countries that do have scope for monetary policy have become disenchanted with the use of monetary aggregates as a nominal anchor. Why?
For one thing, the relationship between money and inflation has weakened as inflation has stabilized. The average CPI inflation rate in a sample of 64 emerging market and low income countries fell by half, from 18.6 percent during 1990-2002 to 9.3 percent in 2002-2012, and the volatility around those averages has caome off sharply as well. Although money does still significantly matter for inflation, in cross-country regressions, the coefficient on money growth has declined sharply (IMF (2014b)). Similarly, financial deepening and greater monetization have led to a decline in the velocity of money, while money multipliers have trended upward, reflecting greater interest rate sensitivity stemming from financial inclusion. Innovative payments technologies, such as mobile banking (M-pesa) have played a role by expanding access to finance.
Sub-Saharan Africa: Inflation and Money Growth
Greater central bank independence and reduced fiscal dominance in Africa have also dented the case for money targeting, which some had previously felt was a way to bolster fiscal discipline. Direct central bank financing of the government budget deficit has declined sharply in Africa, from an average of 12 percent of GDP during 1990-2000, to only about 2 per cent of GDP in 2012.
Similarly, greater exchange rate flexibility in sub-Saharan Africa has enhanced the scope for independent monetary policy. The number of `soft peg' regimes in Africa fell from 28 in 2007 to 11 in 2012, allowing monetary authorities to pay greater attention to fighting inflation (IMF (2014b)). At the same time, a number of countries (such as Ghana, Kenya and Uganda) took steps to open their capital accounts, which enhanced the role of interest rates in their monetary policy frameworks
If not money, what do you target?
Since the use of a monetary aggregate as nominal anchor is losing favor, and exchange rate pegs generate well-known risks, what is a central banker to do? The main alternative is some form of inflation targeting. Long used by many advanced economies - and without getting into the debate over whether monetary policy should aim at both low inflation and financial stability (Lagarde (2014)) - inflation targeting has much to commend it. But aren't there preconditions which need to be satisfied before an emerging market or developing country "qualifies" for inflation targeting?
The early literature on inflation targeting in advanced countries emphasised the concept of preconditions - like central bank operational independence, the absence of fiscal dominance, deep financial markets, and a well-understood monetary transmission mechanism. Yet some research at the IMF suggests that a number of the countries which successfully adopted inflation targeting didn't initially meet all, or even many, of these preconditions (Freedman and Otker-Robe (2011)). In fact, the preconditions were often met after a country adopted inflation targeting, suggesting that the direction of causality could run the other way. Maybe countries adopting inflation targeting are then strongly motivated to put in place supportive institutions, such as more robust central bank independence, better and more frequent macroeconomic data, financial development, and enhanced analytical and modeling capacity for the monetary authorities. In my view that is what we are seeing in Africa.
A recent IMF conference in Maputo, Mozambique, emphasised the progress African countries have made over the past decade (see). Sound macroeconomic policies have, despite the global financial crisis, permitted Africa to become the second fastest growing region (after Asia), and have set the stage for continued growth over the coming years (Sayeh (2014)). But with growth and financial deepening and sophistication have come demands for more efficient and transparent monetary policy frameworks.
South Africa and Ghana have had formal inflation targeting regimes for several years, and more recently Uganda has joined them. Their inflation performance has been somewhat mixed, and it would not be correct to say that inflation targeting is becoming the norm on the continent. Nevertheless, a number of other countries, particularly in East and Southern Africa, have taken steps to introduce elements of inflation targeting into their monetary policy frameworks as well (IMF (2014b)). Kenya, Mozambique, Rwanda, Tanzania and Zambia all clearly announce a forward inflation objective, and outline the glide path to achieve it. They rely principally on indirect methods of liquidity management, including repos/reverse repos and open market operations. Their Monetary Policy Committees meet regularly, holding press conferences at which the Governor announces their policy rates and surrounding corridors with the aim of anchoring market expectations. These practices bear strong similarities to those of inflation targeters from other regions (see IMF (2014a) for case studies on the Dominican Republic and Moldova).
Has inflation targeting worked in Africa? Macroeconomic outcomes are not perfect, but the region as a whole is growing rapidly. There is a robust consensus around low and stable inflation, and the various country authorities' ability to manage volatility (including that stemming from their largely open capital accounts) has improved. It would be hard to argue that the macroeconomic risks and challenges these countries face stem from their choice of inflation targeting as a monetary policy framework.
India is certainly not Africa, and the Indian authorities will have to find their own way with this debate. Yet there are similarities, may be lessons, for India in the African experience. Our understanding of the monetary transmission mechanism in India is relatively poor, and that should not be discounted (an important point noted in Mishra and Montiel (2012)). Macroeconomic data quality could be enhanced. At least on paper an element of fiscal dominance can be said to persist. And while the RBI has a fair degree of de facto independence, its de jure independence is less robust does not. But markets do crave a clear and consistent monetary policy framework, and the gradual opening of India's capital account will only make that more important over time. The adoption of some form of inflation targeting by so many countries in sub-Saharan Africa implies that India can, if it wants, adopt an appropriate form of inflation targeting as well.
Freedman, Charles, and Inci Otker-Robe (2011), "Important Elements for Inflation Targeting in Emerging Economies," IMF Working Paper WP/10/113.
IMF (2014a), "Conditionality in Evolving Monetary Policy Regimes," IMF Policy Paper, March 2014 (press release and paper).
IMF (2014b), "Improving Monetary Policy Frameworks," Chapter 3 of Sub-Saharan Africa Regional Econoimc Outlook: Fostering Durable and Inclusive Growth, April 2014.
Lagarde, Christine (2014), "Navigating Monetary Policy in the New Normal," Speech given at the ECB Forum on Central Banking, May 25, 2014.
Mishra, Prachi, and Peter Montiel (2012), "How Effective is Monetary Transmission in Low-Income Countries? A Survey of the Empirical Evidence,"IMF Working Paper WP/12/143.
Sayeh, Antoinette (2014), "For Africa, Good Policies Bring Good Prospects," iMFdirect blogpost, April 24, 2014.