Policy: lack of tools and a drought of data

Abstract

The Reserve Bank of India has been contemplating adopting Inflation Targeting (IT) in India and replacing the time-tested multiple indicator approach (MIA) used successfully since 1998. As the name indicates, MIA covers different aspects of the economy like exchange rates, growth, liquidity conditions in the market, financial stability of institutions, employment and also inflation, while the focus of IT is only inflation. It is for this reason that since the onset of the global financial crisis, the major economies are shifting towards MIA and shunning away from IT.

An important consideration in IT is the ability to apply the Taylor Rule (TR), named after Prof John Taylor of Stanford University. In fact, interest rate adjustments are attempted by the central bank based implicitly on TR which implies calculation and forecast of output gap and deviations of inflation from the stipulated target. The estimation and forecast of output gap, and interest rate path involve use of many sophisticated econometric tools which India lacks. These tools are like the telescope which gives the policy maker a peep into the future.

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