NGDP targeting is the forward for India
Jeff Frankel has a good piece on Project Syndicate on why Emerging Markets central banks should target nominal GDP. This is Jeff:
...These countries’ (Emerging Markets) need to establish policy credibility tends to be more acute, whether as a result of histories of high inflation, an absence of credible institutions, or political pressure to monetize budget deficits. They need targets with which they can really live. Nothing seems to work. When the International Monetary Fund comes around asking what their nominal anchor is, many declare themselves to be inflation targeters. But they have trouble abiding by their targets. If they are hit by an adverse supply shock or terms-of-trade shock in the meantime, the right step would be to loosen monetary policy sufficiently that the currency depreciates. But targeting the consumer price index precludes this, because depreciation would raise the price of imported oil, food, and other tradable commodities. Indeed, if the shock is an increase in the dollar price of oil, an inflation target in theory dictates tightening monetary policy enough that the currency appreciates. But such a policy would mean that the adverse shock is reflected in a sharp fall in output. In practice, an inflation-targeting central bank usually abandons the target for price stability in such a case. It tries to explain the failure to the public in terms of “core inflation”: what has happened is only an increase in the cost of filling their gas tank or buying groceries. But this defeats the very purposes – transparency, credibility, and predictability – for which a target was announced in the first place. Emerging-market countries ought to consider targeting nominal GDP. Relative to inflation targeting, the great virtue of NGDP targeting is that it is robust with respect to supply shocks and terms-of-trade shocks, meaning that the central bank is not faced with a choice between abandoning the target and hurting the economy. Proposals to target NGDP are familiar in major industrialized countries, first arising in the 1980s. In the wake of sharp price increases in the 1970s, central banks wanted to commit credibly to monetary discipline in order to facilitate disinflation. The proposal was never adopted. Yet the idea was suddenly revived two or three years ago. The context this time was a desire to achieve expectations of greater monetary stimulus, in order to facilitate recovery from the great recession of 2008-2009. There are good reasons to think that NGDP targeting is better suited to emerging and developing economies than to industrialized countries. These economies are more frequently subject to adverse terms-of-trade shocks, such as increases in world oil prices or declines in prices for their commodity exports. Their economies also tend to suffer larger supply shocks from natural disasters, other weather events, social unrest, and unexpected productivity changes. The advantage of a nominal GDP target is that adverse shocks of these sorts are reflected equally in output and inflation, rather than imposing the entire burden in the form of a loss in output. This provides the sort of response that one would want anyway, while still retaining the advantages of a rule (communicating the central bank’s plans in such a way that it can live with what it has promised to do). Many emerging and developing countries need to bring inflation down, much as advanced countries needed to do 30 years ago. One example is India, which is currently considering adopting inflation targeting to enhance monetary discipline. But the country is regularly hit by supply shocks such as good or bad monsoons. Statistical estimates suggest that an attempt to set the path of inflation in the face of such shocks would lead to undesirably large swings in real GDP, compared to anchoring policy to the path of NGDP. The target path for nominal GDP can be set at whatever level of monetary discipline is desired. The robustness of NGDP targeting to unknown future shocks is similar whether the objective is to ease money, tighten money, or stay the course, and whether the central bank wants to announce a forecast, a target range, or a threshold for forward guidance. If it is worth communicating a plan, it is worth choosing a plan that one can live with. NGDP targeting is that plan.Jeff obviously is completely right. In fact even though I think that there are very good arguments for developed economies to target the NGDP level I in fact think that the arguments are even stronger for Emerging Markets. The reason for this is that supply shocks - as the Indian monsoon or political unrest - are more common in Emerging Markets than in developed economies. Therefore, even though inflation targeting can be problematic in developed economies it is even more problematic in Emerging Markets. To illustrate this point take a look at this "Phillips" curve for Indian from my earlier post In Indian inflation is always and everywhere a rainy phenomenon: As I explained in my "rainy post":
A closer scrutiny of the Indian inflation data will actually show that the swings in Indian inflation primarily is a rainy phenomenon. Hence, the Indian monsoon and the amount of rainfall greatly influences the food prices and as a result short-term swings in inflation is primarily due to supply shocks in the form of more or less rainfall. Obviously if the Reserve Bank of India (RBI) was following a strict ECB style inflation target then monetary policy would be strongly pro-cyclical in India as negative supply shocks would push up inflation and down real GDP growth and that would trigger a tightening of monetary policy. This would obviously be an insanely bad way of conducting monetary policy and the RBI luckily realises this. The RBI therefore focuses on wholesale prices (WPI) rather than CPI in the conduct of monetary policy and that to some extent reduces the problem. The RBI further try to correct the inflation data for supply shocks to look at “core” measures of inflation where food and energy prices are excluded from the inflation data. However, the problem with use “core” inflation that it is in no way given that changes in food prices is driven by supply factors – even though it often is. Hence, demand side inflation might very well push up domestic food prices as well. Hence, it is therefore very hard to adjust inflation data for supply shocks. That said it is pretty hard to say that the RBI has followed any consistent monetary policy target in recent years and inflation has clearly been drifting upwards – and food prices can likely not explain the uptrend in inflation.Therefore, I fully agree with Jeff that it would make a lot more sense for the RBI to implement a NGDP target rather than a inflation target. What should be the NGDP target?