Economic Highlights

New Delhi, 12 April 2007

Reserve Bank’s Role

Controlling Inflation Canadian Style

By Dr. Vinod Mehta

Inflation has been a worldwide problem and most of the governments across the world have to tackle it one way or the other as it not only erodes the real incomes of the people but also hurts the economy over a period of time. Moderate Inflation rate of two to three per cent may be tolerable but inflation rate going beyond five per cent  becomes a political hot potato.

President Jimmy Carter was seriously bothered about inflation during his Presidency.  In a televised speech on October 24, 1978, he said: “I want to have a frank talk with you tonight about our most serious domestic problem. That problem is inflation. Inflation can threaten all the economic gains we've made, and it can stand in the way of what we want to achieve in the future. “This has been a long-time threat. For the last 10 years, the annual inflation rate in the United States has averaged 6-1/2 percent. And during the 3 years before my inauguration, it had increased to an average of eight percent.

“Inflation has, therefore, been a serious problem for me ever since I became president. We've tried to control it, but we have not been successful. It's time for all of us to make a greater and more coordinated effort. “If inflation gets worse, several things will happen. Your purchasing power will continue to decline, and most of the burden will fall on those who can least afford it. Our national productivity will suffer. The value of our dollar will continue to fall in world trade.”  Inflation continued and Jimmy Carter did not get the second term.

China has also been bothered by this problem.  In Vietnam, which is considered to be “emerging China”, consumer prices in the first eight months of 2006 rose from 4.8%, mainly prompted by high fuel prices and interest rate-driven high production costs, to 7.5%.

In India too the rate of inflation was around 17% in 1991, which was brought down to the level of seven per cent in 1993.  As recently as 2004 the rate of inflation was around six per cent.  And most of the time the Reserve Bank of India has responded by restricting money supply as all the Central Bankers do.

The problem at the moment is that inflation has raised its ugly head at a time when the economy is growing at the rate of about nine per cent and the Government fears that any hike in interest rates and credit curbs would lead to a decline in growth rates.  For instance, a hike in the interest rates for home loans or car loans will lead to decreased demand for homes and cars which in turn will affect the growth rate of vehicle and construction industries.  Higher interest rates would also add to the cost of production when the loans are taken by the business and finally affect the growth rate.  It appears that in India the Government and the Central Bank do not see eye to eye on the ways to curb inflation; this is also true of many other countries.

But the Central Bank and the Government in Canada have found a way to cooperate in keeping the inflation under control.  The Government of Canada and the Central Bank of Canada have developed “inflation-targeting framework”  Instead of working at cross purposes both the Government  and the Central Bank have signed a kind of MoU to keep the inflation under control.  This has been going on for the past 15 years and this agreement is signed every five years. 

To quote from their recent Joint Statement: “The primary objective of Canada's monetary policy  is to enhance the well-being of Canadians by contributing to sustained economic growth, rising levels of employment and improved living standards. Experience has clearly shown that the best way monetary policy can achieve this goal is by giving Canadian households and businesses confidence in the value of their money.

“It has been 15 years since Canada adopted an inflation-targeting framework to guide its monetary policy. During this time, Consumer Price Index (CPI) inflation has been reduced to a low, stable and predictable level of close to 2 per cent, real output has expanded at an average rate of 3 per cent per year and the unemployment rate has fallen to a 30-year low. Although a generally supportive international environment, coupled with significant domestic economic reforms and a prudent fiscal policy track, has played an important role in these positive developments, a key contributor has been Canada's monetary policy under the inflation-targeting framework.

The joint commitment of the Government of Canada and the Bank of Canada to the inflation targets has helped anchor inflation expectations. It has also provided a more stable and certain economic environment in which Canadians can make their investment and spending decisions.”

This agreement has been further extended by five years up to 2011.  As per the renewed agreement, the target will continue to be defined in terms of the 12-month rate of change in the total CPI (Consumer Price Index) and the inflation target will continue to be the 2 per cent mid-point of the 1 to 3 per cent inflation-control range.

The first such agreement was signed in 1991 when the rate of inflation in Canada was 5.9 per cent.  The  rate now ranges around two per cent.  Canada has found that  inflation-control target assists the Central Bank in determining what monetary policy actions are needed in the short and medium term to maintain a relatively stable price environment.  To achieve a rate of monetary expansion consistent with the target range, the Bank of Canada uses its influence on short-term interest rates.

If inflation is moving towards the top of the 1 to 3 per cent target range, that is usually a sign that demand in the economy for goods and services needs to be restrained through a rise in interest rates. If inflation is moving towards the bottom of the range, it is often a sign that demand is low and needs some support through a reduction in interest rates.

In this way, Canadian experience shows, monetary policy tied to an inflation-control target tends to act as a growth stabilizer. Ensuring economic growth at a sustainable pace means preserving past gains by avoiding a recurrence of the inflationary "boom-and-bust" cycles of the early 1980s and 1990s. It also means encouraging long-term investment in future growth and job creation by maintaining a stable, low-inflation environment.

The lesson from the Canadian experience is that the Reserve Bank should not act only when the inflation rate goes out of hand but act throughout the year by way of  inflation-control target shows.  This is a sure way to avoid recession which tight money policy (severe curbs on credit creation, higher interest rates etc.) may bring. 

The Ministry of Finance and the Reserve Bank of India should sit across the table and develop inflation targeting framework. The need of the hour is to preserve higher growth rate with moderate inflation over a longer period of time.  In the 1990s the tight monetary policy of the RBI to control inflation, which was raging at seven per cent, led to severe recession; that needs to be avoided now.---INFA

 (Copyright, India News and Feature Alliance)