Rupee and Inflation Targeting: A disconnect and a debate

To reiterate its commitment, the RBI has changed its stance from “neutral” to “calibrated tightening” indicating its readiness to hike rates if data demands.

The reason for the current pause is entirely because it sees the inflationary impact of higher crude and cheaper rupee to be countered by the rather severe disinflation in food prices.

RBI governor Urjit Patel and deputy governor Viral Acharya, when asked if the “no-action policy” indicated they were comfortable with the fall in the rupee, detailed their inflation fighting rationale. The governor said, “The mandate of the Monetary Policy Committee is a legislated one and it is a flexible inflation targeting mandate for an inflation of 4 percent, plus or minus 2 percent. To the extent all domestic and international factors, including rising commodity prices affect our inflation outlook, that is internalised in our inflation forecast and the risks are already baked in our forecasts and our decision. Prior to this policy we have already delivered two rate hikes in literally two months and today’s change in stance also means that in the current rate cycle, a rate cut is off. We are not bound to hike rates in every meeting. As new data comes in we will look to change policy accordingly. Calibrated tightening is the appropriate policy given our inflation forecasts and financial conditions.”

Acharya further explained, ”Exchange rate is a price and the rupee-dollar market is a fairly deep one where the exchange rate is determined by forces of demand and supply. The Reserve Bank’s policy has been to manage undue volatility and not to target a particular level. Exchange rate adjustment is an important way in which an economy adjusts to trade shocks. As far as interest rates are concerned it is focused primarily, indeed exclusively focused on inflation-targeting.”

Probably there will be more calm next week as the financial markets digest the gravity of this explanation over the weekend.

That said, there is another interpretation that could be preoccupying markets, economists and policy pundits. The rupee fell probably because Indian and global investors are used to perceiving the RBI as a 'full-service' central bank and not just an inflation targeting monetary authority. The appointment of the Monetary Policy Committee (MPC) and the passing of the Monetary Policy Framework by the government giving the MPC an explicit inflation target of 4 percent (+/-2 percent) has shrunk the RBI’s role from that of an all pervading protector of financial stability to a focused inflation targeting monetary authority. But the financial markets are probably unused or unhappy with this change.

The RBI's explanation has probably left market participants worrying that if the central bank is solely focused on inflation, then who is responsible for financial or external sector instability.

It is possible North Block and the government too have not understood the full gravity of this pure interpretation of the inflation target mandate. It is likely that even if financial markets have understood this ideology they are not comfortable with it.

In 2014, when the RBI, on the basis of the Urjit Patel Committee Report on Monetary Policy first shifted to the ideology of inflation targeting, many economists and central bankers had argued against it. Dr YV Reddy, in particular, had pointed out that globally many inflation targeting central banks had, after the global financial crisis, become convinced of the inadequacy of this purist approach and had expanded their role to include financial stability. Reddy had argued that in countries with inflation targeting central banks, the financial crisis showed up the policy vacuum (of no one being in charge of overall financial stability) and everywhere central banks had to move in to fill that vacuum.

This is the first time since India formally adopted inflation targeting that the country has been faced with a sharp depreciation of its currency. At its low today of 74.12 per dollar, the rupee had depreciated by 16 percent year-to-date, only marginally less than the 19 percent that the South African rand has depreciated this year (an unhappy comparison since the Indian economy is growing at 7 percent while the South African economy is contracting).

The sharp fall in the currency post the policy led to a domino effect on the stock markets which sold off over 2 percent. It is not for the RBI to worry about every move in financial markets. But the fall in the rupee market was probably interpreted by equity markets that foreign investors are fleeing the currency and the fall in equities was in turn pushing down the currency leading to a destabilising spiral in both markets. Yes, the RBI intervened heavily in late trade and yanked up the rupee. Was this wasting of bullets needed though?

Would it have been better for the RBI to pursue its inflation targeting mandate but communicate it to the markets in a less purist and deliberately more vague fashion? Or is it better if the RBI, despite its inflation targeting mandate, accepts financial stability as its core responsibility, simply because it is the only one with the understanding, the tools and the power?

Or, to put it more theoretically, given that India does not have a fully open capital account, is it necessary to come to terms with the impossible trinity argument and not have a pure inflation targeting central bank? And, if one is hell bent on inflation targeting, would it have been wiser not to communicate this position so unequivocally, especially when financial markets are restless?

These questions need to be debated.