All Emerging Markets (EMs) including India, U.S. As foreign portfolios are facing investment outflows irrigated Tightens. These surges and abrupt stops due to changes in global risk were a major reason for the lower growth of EM in the 2010s compared to the previous decade. Excessive volatility in financial variables damages the real sector. The lesson for EM policy is to minimize volatility as much as possible.
of Cannon inflation Targeting wants exchange rates to flow as a true response to capital flows. Policy should respond to exchange rate fluctuations only if they affect inflation or output. Any interest rate defense of the exchange rate will reduce the focus on inflation. But policymakers disagree because most EMs intervene in the foreign exchange (FX) markets to reduce volatility. As Edward F. Buffy and co-authors point out in a 2018 paper, this poses a serious problem for a theory whose position seems to be: So what if floating doesn’t work in practice, it works in theory. Is. Their research shows that FX interventions significantly enhance the efficacy of inflation targeting. Two instruments for two goals work better than trying to do everything through interest rates. Excessive depreciation in thin markets can exacerbate inflation. Markets can get bogged down in cumulative one-sided bustle and panic.
Many other researches, including those of the IMF, argue for the use of prudent capital flow management techniques and find reserve accumulation and its use reduce risk and distress in EM.
There are all such policies in India. Its indexed approach to capital account convertibility, where, for example, credit flows are only allowed as a percentage of domestic markets, protected it from the kind of interest rate volatility that Indonesia experienced during the taper tantrum and Its helping now. If needed, further liberalization measures can be taken. The temporary exemption announced on July 6 is an example. India’s large forex reserves on the strength of the dollar have allowed the rupee’s depreciation to be lower as compared to other countries.
Yet inflation targeting purists strikes for RBI intervention no matter what, given that India has achieved higher growth and lower inflation than most countries in these difficult times. Never mind that it is dangerous to apply textbook economic theory based on perfect markets regardless of time and place. Such market purists, and those who would profit from the additional business, have long been pushing India towards full capital account convertibility. If he had followed that advice he would be in deep trouble. Capital inflows are welcome but diversify as the domestic market deepens but volatility is inherent.
There are costs of having large reserves and a lot of intervention. The central bank backs the US, not its government’s borrowing, and it sacrifices interest income. But keeping reserves and then not using them when needed is the most expensive. Again the use of multiple devices can reduce the over-reliance on interference.
Much research and recent experience suggests that all available tools should be used to reduce volatility in the nominal variable. This will prevent additional deviations of real variables, such as real interest and exchange rates, from equilibrium levels. These affect, and deviations can distort, real field judgments. In the last decade when Indian growth and investment rates declined, real interest rates ranged between 10 and 6 per cent. While depreciation benefits some exporters, all are hurt by the greater volatility of exchange rates.
The suggested simplified solution is what everyone wants from this approach. A common suggestion is to raise policy rates to maintain a historical gap with US Fed rates. But such interest rate defenses did not prevent outflows during the taper tantrum or in 2018 and only led to a downturn. It forgets that interest-sensitive flows account for only 8 per cent of India’s foreign liabilities. Some of it is quite sticky. Despite the narrow interest differential, there has been no debt outflow in 2022. Equity outflow also appears to be slowing down. Monetary tightness that lowers growth expectations prompts more outflows as the country’s risk-premium rises. Some commentators believe that Indian inflation should rise with that of the US and, therefore, want to increase rates. They forget that India did not have additional fiscal stimulus and its labor market is not tight. Its policy rates must respond to its own inflation.
Another group wants less interference and more depreciation of the rupee so as to improve current account deficit, But less intervention can lead to chaotic downtrends and market turmoil as we saw in 2011. As inflation rises with nominal depreciation, real appreciation will result, defeating policy. It is genuine appreciation that affects business. It is best for the policy to prevent excess depreciation due to global risks. After a nominal depreciation of around 4 per cent, India’s real effective exchange rate against a basket of 40 countries is approaching 100. This means that the real exchange rate is depreciating much more as India has undergone relatively greater structural reforms and productivity growth. Future correction towards equilibrium would require an increase of Rs. Higher oil prices are a risk to India’s balance of payments, but a range of adjustments have the best chance of being successful.
Market participants want clear communication and there are no surprises for the markets. Forward guidance is an important part of inflation targeting. But when markets react more and are more influenced by the US than by Indian policy, the best way to drive policy change may be a surprise. Thus the markets had hiked rates excessively after the US Fed tightened. The sudden increase in Indian repo rates prevented additional rate hikes as domestic rates began to rise. Yields have really softened now. The overnight index swap rate, which is heavily influenced by foreign non-deliverable futures markets, had raised expectations. repo rate rose to 7.34 percent and has since fallen to 6.77 percent. To make correct predictions, markets should focus more on Indian conditions and internalize inflation targeting. Inflation targeting and the market both together have to mature further.
Inflation targeting is an art that requires skill, attention to context, and an open mind.
The author is a member monetary policy committee and Emeritus Professor, IGIDR.