Reading recent MPC minutes: Does RBI follow lexicographic flexible inflation targeting?

RBI released the MPC minutes for its August 2017 meeting yesterday.

One of the members Prof Chetan Ghate first said though there are risks that inflation could again rise, subdued growth is a bigger concern. In the process, he remarked  something which caught my attention:

29. A lexicographic flexible inflation-targeting mandate requires monetary policy to now accommodate the objective of growth.

Lexicographic? It means the process of writing dictionaries where you move in hierarchy to compile the different words. So you follow the alphabetical order from A to B and so on to organise the different words.

This idea was used in economics to order preferences. So if you prefer A to B, you will always prefer a choice which offers more A even if the alternate choice has more items in total. So if bundle 1 has (5,6) of goods and bundle 2 has (4, 8) of goods, you prefer bundle 1 as it has more A despite Bundle B having more goods in total.

In terms of inflation targeting, we broadly had two types:

  • Strict inflation targeting aims at stabilizing inflation only, without regard to the stability of the real economy.
  • Flexible inflation targeting means that monetary policy aims at stabilizing both inflation around the inflation target and the real economy.

Prof Ghate says Lexicographic Flexible inflation targeting which basically means two things. First, RBI is trying to stabilize both inflation and real economy. Two, there is a hierarchy between objectives: first is inflation followed by real economy. Which is why he says, as inflation is within the target, “A lexicographic flexible inflation-targeting mandate requires monetary policy to now accommodate the objective of growth.”

In a paper in 2006, Willem Buiter said:

The lexicographic ordering means that the monetary authority chooses a short nominal interest rate rule or a state-contingent sequence of short nominal interest rates to minimize first the following (‘conservative central banker’) objective function, defined just over deviations of inflation from its
target rate If the optimal rule/state-contingent sequence is unique, that is the end of the matter. If there are multiple optimal rules/sequences, the authority chooses from among these the one that minimises the present discounted value of current and future expected squared output gaps.

Only subject to, or without prejudice to, the price stability objective being met, can the authorities legitimately pursue other objectives such as employment, output or happiness. Such mandates imply lexicographic or hierarchical inflation targeting, not flexible inflation targeting.

The belief that monetary policy could and should trade off expected inflation for the expected output gap was shattered by the combination of the intellectual brilliance of three Nobel Prize winning economists (Phelps, Friedman and Lucas) in  the 1960s and 1970s, and a recalcitrant reality in the 1970s and 1980s. Likewise, the hubris that has led some leading central banks (but not the ECB or the Bank of England) to adopt the flexible inflation targeting objective function (7), will be shattered when it leads to an unintended and unexpected drift of the inflation rate above its target value. Indeed, there already is some evidence that flexible inflation targeting may have morphed into soft inflation targeting in a number of countries, including the US, Australia and New Zealand. The obvious and simple solution to this problem is to jettison flexible inflation targeting and to adopt lexicographic inflation targeting instead.

Hmm..Though the problem has reversed in recent years with inflation undershooting the target for quite some time in most of the advanced economies.

So, Hard IT is based on the monetarism thing: Central banks should be just dealing with inflation. Flexible IT is this New Keynesian thinking where you continue to think that you could tinker with both inflation and growth. Lexicographic IT is back to monetarism but gives some room to other objectives in a hierarchical manner.

Now what does RBI Act say. As per RBI’s Preamble:

“to regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage; to have a modern monetary policy framework to meet the challenge of an increasingly complex economy, to maintain price stability while keeping in mind the objective of growth.”

Is this Flexible IT or Lexicographic IT? RBI defines it as Flexible IT:

The goal(s) of monetary policy

  • The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.
  • In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.
  • The amended RBI Act also provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once in every five years. Accordingly, the Central Government has notified in the Official Gazette 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.
  • The Central Government notified the following as factors that constitute failure to achieve the inflation target:(a) the average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters; or (b) the average inflation is less than the lower tolerance level for any three consecutive quarters.
  • Prior to the amendment in the RBI Act in May 2016, the flexible inflation targeting framework was governed by an Agreement on Monetary Policy Framework between the Government and the Reserve Bank of India of February 20, 2015.

But if we read the fine print then clearly price stability takes hierarchy over growth as the first statement says:

  • The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.

So if inflation is rising and growth is falling, addressing higher inflation shall take precedence over falling growth. Only when inflation is within target then growth if falling shall be given some considerations. This is what the MPC member also says: “A lexicographic flexible inflation-targeting mandate requires monetary policy to now accommodate the objective of growth.”

But then he should just call lexicographic inflation-targeting and not mix it with flexible inflation-targeting.

So much so for Monetary economics semantics.

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