A Nominal Income Target in Emerging Markets

Pranjul Bhandari and Jeffrey Frankel argue that the case for nominal income targeting over inflation targeting is stronger in developing countries than their advanced counterparts. The crux of this argument relies on the increased frequency of supply-side shocks in poorer countries, which require perverse policy under an inflation targeting regime.

I’m ambivalent about both the relevance and efficacy of this proposal. It’s a debate we desperately need to have, but it’s not like two of the most important emerging markets (India and China) follow any target to begin with. However, I think nominal income targeting has a few critical benefits the authors (at least in the VoxEu summary) do not cite.

Inflation is hard to define, let alone measure, in rich countries. And a lot harder in poor ones. A common measure of inflation in the United States, the Consumer Price Index, considers the price level a representative agent faces. In places like the US and Europe, it’s pretty easy to outline the parameters that define a representative agent, and the basket of goods he consumes. With a bit of econometric handiwork, the Bureau of Labor Statistics (BLS) has developed sophisticated tools to update the CPI to keep it relevant with a modern consumer. 

Inequality in America may be high, but the overwhelming number of citizens care about the same things: price at the pump, the cost of bread, and so forth. A broad consumption-driven middle-class buys the same stuff. In India, as in many other developing countries, the urban middle-class lives a world apart from its poorer, rural cousin. This has an important macro dimension. The cost of tradables (and hence the exchange rate) matters a lot more for an IT worker in riding a scooter to work than a casual laborer in the heartland of Haryana. 

There is also a lot of uncertainty around the portion of rural transactions that are even monetary in nature, with informal markets and even non-money exchange an important part of life. 

So in the United States, when inflation unexpectedly jumps, it’s a little hard to say who the winners and losers are. In India, to the large extent perishables drive prices, jumps in inflation largely reflect higher wages in rural districts reflected as higher prices in urban fringes. 

There is no representative basket.

Measurement in India is also confounded by tricky conflicts of interest. The bureaucrats that estimate inflation have wages expressly indexed to the CPI-IW. This probably is an order of magnitude or two less important than the more philosophical problems with inflation, but given its slight upward bias over the past decade not something to ignore altogether either. 

Unlike inflation, price level, and real GDP, nominal GDP is something we can estimate pretty well and, more importantly, have an extremely clear definition to work with. This is an enormous advantage in favor of a NGDP based anchor. 

But currently, India doesn’t target anything, and there’s probably good reason for that. Monetary operations in developing countries are in many ways more complex, if less consequential, than those in advanced markets. For example, the Indian economy is far more sensitive to the exchange rate than most rich countries (especially the United States) are. Sensitive both because of institutional arrangements (such as fuel subsidies) whereby the terms of trade are important and because of volatility in capital flows, particularly short-term debt. 

Specifically because India imports certain dollar-priced goods (oil, but other minerals too) the exchange rate affects not only demand, as in most countries, but also supply. A depreciation can lead to unsustainable deficits and infectious inflation much quicker than in advanced countries. 

Fiscal dominance, or at least political interference, is a much larger concern. As Raghuram Rajan noted not long before he was tapped as the RBI chief, by imposing high liquidity requirements on banks – held through Indian government debt – the RBI was effectively financing artificially-cheap borrowing by the Centre. 

So one may ask – a nominal income target, but in what? Nominal rupees or nominal dollars? Or nominal trade-weighted units? It’s a bit like whack-a-mole. A nominal income target in a foreign currency, while something I definitely need to think more about, comes dangerously close to certain worries of competitive devaluation. However, it does at least intuitively deal with most of the problems of just an inflation target, or just a nominal income target.

A final problem with rules-based, as opposed to ad hoc, monetary policy is low labor mobility and dearth of a strong fiscal transfer system. If America is booming, but Alabama is sagging, a deep social safety net via food stamps, unemployment insurance, and social security ensures that an inflation-targeting Fed doesn’t harm Alabama too much with monetary tightening. And wages will move towards equality as Alabamans move out, reducing local supply. But that’s not the case in India, suggesting monetary moves have far more political implications, the rural-urban divide key among these.

I find any sort of long-run target that doesn’t consider exchange rates to be worrisome in the world of free and fickle capital. I’ll be writing more about a dollar-denominated nominal income target for emerging markets in the days to come, but am curious to see what people think about this. However, given the problems with measuring inflation I think we can be sure that were India to choose between the two, it should chart its own course instead of copying the Reserve Bank of New Zealand.