BS Sajjid Chinoy
Inflation targeting is precisely consistent with the transparency and predictability that the Governor pledged on day one
Public memories are short. Especially those in the financial community. Since the start of 2014, even before the election, India started to re-emerge as the darling of emerging markets. Portfolio inflows were pouring in again, the current account deficit had more than halved, and the fiscal consolidation was seen as being non-negotiable. Growth was weak but, hey, at least macro stability had returned.
But as we bask in the current glory, it's important to think back to only 12 short months ago. At the first hint of a taper last year, India's bloated current account deficit and excessive dependence on portfolio flows stood badly exposed. The rupee went into a free fall and currency expectations got unhinged. A plunging rupee, in turn, engendered concerns of even higher inflation and severely pressuring the fisc, in turn creating concerns about a ratings downgrade. Any such event would have put even more pressure on the rupee. In short, India was in the midst of a vicious self-fulfilling cycle.
It was amidst this carnage, that Governor Rajan took office. On his first day, the new Governor laid out several priorities. But, two things stood out. The first was his pledge to restore confidence in the value of a country's money, both external and internal. And the second was to make the central bank even more transparent and predictable.
A year later, RBI has made giant strides on both fronts. For starters, rupee expectations have become firmly anchored, aided by a sound strategy and nimble tactics. RBI has correctly decided that, even as the currency needs to serve as a shock absorber, it shouldn't suddenly veer too far away from its fundamental value for fear of unhinging expectations. It's a fine balance, but RBI has got it right thus far. And the approach has been symmetrical. RBI resisted a sharp post-election appreciation that would have put the tradable sector at a competitive disadvantage. Instead, it intervened at every possible opportunity, to build up a war chest of reserves so as to begin to ring fence India from global shocks as the Fed begins to normalise.
Accompanying this strategy has been sound day-to-day tactics. The manner in which oil demand was re-introduced and FX intervention has been conducted has been deft. But while the rupee operates in a band in the near-term, one would expect that its trajectory over time reflects India's inflation and productivity differentials with trading partners.
While the currency has been Governor Rajan's most tangible success, I would argue that its sustainability depends crucially on the other important goal RBI has pursued: flexible inflation targeting. The confidence in a country's money can only be achieved if inflation and inflation expectations, which have become unhinged, are brought under control. And, as much as we may wish it away, a transparent and credible commitment to reducing inflation in emerging markets(flexible inflation targeting) has been the only strategy that has worked around the world to disinflate from high levels. It's only when central banks succeed on this front that the space to pursue other objectives, without disturbing inflation expectations, opens up. Inflation targeting is precisely consistent with the transparency and predictability that the Governor pledged on day one.
One may ask these two key objectives - stabilising the rupee through intervention and inflation targeting - potentially in conflict? Does inflation targeting necessarily require a completely floating exchange rate? Not necessarily. To the extent that central banks have other "instruments" (FX reserves, macro prudential measures) the repo rate can be dictated largely by inflation even as the FX is influenced through other instruments.
To be sure, challenges abound: Shaping a banking sector that can more efficiently intermediate resources between savers and borrowers, changing the incentives under which public sector banks operate, further deepening financial markets to create a financial sector that can grease the wheels of a fast-growing economy.
But before looking ahead, it's always instructive to look back. A year ago, India was a founding member of the Fragile Five Club. Today, we're becoming the darling among emerging markets. Governor Rajan and the RBI have had a crucial role to play in facilitating that transition.
But as we bask in the current glory, it's important to think back to only 12 short months ago. At the first hint of a taper last year, India's bloated current account deficit and excessive dependence on portfolio flows stood badly exposed. The rupee went into a free fall and currency expectations got unhinged. A plunging rupee, in turn, engendered concerns of even higher inflation and severely pressuring the fisc, in turn creating concerns about a ratings downgrade. Any such event would have put even more pressure on the rupee. In short, India was in the midst of a vicious self-fulfilling cycle.
It was amidst this carnage, that Governor Rajan took office. On his first day, the new Governor laid out several priorities. But, two things stood out. The first was his pledge to restore confidence in the value of a country's money, both external and internal. And the second was to make the central bank even more transparent and predictable.
A year later, RBI has made giant strides on both fronts. For starters, rupee expectations have become firmly anchored, aided by a sound strategy and nimble tactics. RBI has correctly decided that, even as the currency needs to serve as a shock absorber, it shouldn't suddenly veer too far away from its fundamental value for fear of unhinging expectations. It's a fine balance, but RBI has got it right thus far. And the approach has been symmetrical. RBI resisted a sharp post-election appreciation that would have put the tradable sector at a competitive disadvantage. Instead, it intervened at every possible opportunity, to build up a war chest of reserves so as to begin to ring fence India from global shocks as the Fed begins to normalise.
Accompanying this strategy has been sound day-to-day tactics. The manner in which oil demand was re-introduced and FX intervention has been conducted has been deft. But while the rupee operates in a band in the near-term, one would expect that its trajectory over time reflects India's inflation and productivity differentials with trading partners.
While the currency has been Governor Rajan's most tangible success, I would argue that its sustainability depends crucially on the other important goal RBI has pursued: flexible inflation targeting. The confidence in a country's money can only be achieved if inflation and inflation expectations, which have become unhinged, are brought under control. And, as much as we may wish it away, a transparent and credible commitment to reducing inflation in emerging markets(flexible inflation targeting) has been the only strategy that has worked around the world to disinflate from high levels. It's only when central banks succeed on this front that the space to pursue other objectives, without disturbing inflation expectations, opens up. Inflation targeting is precisely consistent with the transparency and predictability that the Governor pledged on day one.
One may ask these two key objectives - stabilising the rupee through intervention and inflation targeting - potentially in conflict? Does inflation targeting necessarily require a completely floating exchange rate? Not necessarily. To the extent that central banks have other "instruments" (FX reserves, macro prudential measures) the repo rate can be dictated largely by inflation even as the FX is influenced through other instruments.
To be sure, challenges abound: Shaping a banking sector that can more efficiently intermediate resources between savers and borrowers, changing the incentives under which public sector banks operate, further deepening financial markets to create a financial sector that can grease the wheels of a fast-growing economy.
But before looking ahead, it's always instructive to look back. A year ago, India was a founding member of the Fragile Five Club. Today, we're becoming the darling among emerging markets. Governor Rajan and the RBI have had a crucial role to play in facilitating that transition.
The author is Chief India Economist at J P Morgan
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