India's inflation goal needs tougher central bank

The proposed four per cent inflation target is onerous, considering India is currently battling near-double-digit increases in prices, says Andy Mukherjee.

Raghuram Rajan is finally getting his wish: inflation targeting is coming to India. 

But while a resolve to tame price growth to four per cent a year is laudable, the target won't be credible unless the country's central bank is free to punish inflationary fiscal policies with higher interest rates.

A panel set up by Rajan after he became the governor of the Reserve Bank of India (RBI) in September has recommended what the former academic proposed six years ago from his then perch at the University of Chicago: Turn the RBI into an inflation-targeting monetary authority.

The proposed four per cent inflation target is onerous, considering India is currently battling near-double-digit increases in prices. 

The panel suggests bringing the rate down to six per cent in two years before adopting formal targeting. After that, missing the goal for three consecutive quarters will force the central bank to make a British-style public statement explaining why it failed.

Such a statement today would be replete with complaints against the government. For years, New Delhi has been paying farmers too much for their produce, and stuffing money into villagers' pockets via a job guarantee that creates few new assets. 

The government's energy pricing is also cockeyed. And, the reason the state is able to run these inflationary fiscal policies is because its deficits are assured of financing. Banks must park 23 per cent of their deposits in government bonds.

Rajan's plan puts the government on notice. The RBI panel wants New Delhi to cut its budget deficit to three per cent of GDP by March 2017, down from this fiscal year's tough-to-meet 4.8 per cent goal. 

More importantly, the panel suggests pruning the government's assured access to bank financing. New Delhi's control of the prices of food and energy - more than half the country's consumption basket - will also have to loosen.

With inflation bound to sway the outcome of this year's general elections, Rajan's timing is right. Governments can't get re-elected without offering citizens stable prices. 

As long as the RBI can promise to deliver on inflation, politicians will have no choice except to accept a tougher central bank teaching them some unpleasant fiscal arithmetic.