Most central banks have a dual mandate - 'maintain low and stable inflation while promoting economic growth'. Supply shocks like an increase in crude oil prices can cause a temporary conflict between these two objectives.
Not only does an increase in oil price drive up inflation, it also leads to a temporary fall in output. An interesting question is how policymakers should respond to such shocks?
It has often been argued that non-monetary factors like globalisation, excessive business profits and labour unions explain the behaviour of inflation over time. In fact, many in India hold the view that monetary policy is not a potent weapon to control inflation when it is driven by 'cost-push' factors. In such cases, non-monetary measures, like price controls, have been advocated to tackle inflation.
For example, recently India and many other developing countries have adopted policies that prevent a full pass-through of oil and other commodity prices into headline inflation, mainly to shield domestic consumers from the rise in international prices. Such policies distort relative price signals and incentive mechanism.
In contrast, a full pass-through tends to result in the efficient use of expensive energy, a move towards alternatives fuels and investment in improved technology.
In the past, the view that inflation cannot be brought down with monetary policy alone - not without the support of wage, price or credit controls and supportive fiscal policy - prevailed in developed countries also.
For example, in the 1970s, policymakers in both the US and the UK erroneously relied on non-monetary devices to fight inflation. Crucially, such a cost-push explanation of inflation conveniently absolves the government from having any role in creating inflation. Academic research has moved on since then and recent experiences of other countries provide ample evidence that this is a mistaken belief.
The idea that supply shocks - oil or other commodity price increase - can cause a 'continual' rise in prices is not supported by either theory or empirical evidence. This is not to deny that supply failures cause the prices of some commodities, and consequently the overall price level, to rise in the short run. However, to blame them for persistent inflation is, in essence, contending that inflation is uncontrollable.
Moreover, the experience of developed economies in the recent past is inconsistent with this explanation. Over the past two years, crude oil prices have almost doubled. In the 1970s, similar increases set off a sharp increase in global inflation that persisted for almost a decade.
Today, by contrast, core inflation rates in a majority of the developed world remain well-anchored. The potential explanation for this is that monetary policy has not provided the basis for a sustained change in the inflation process by accommodating supply shocks.
But, actually, monetary authorities expanded the money supply to avoid an oil shock-driven recession. This in turn succeeded in transforming what was a temporary burst of inflation into a permanent jump in the level of inflation.
Why did this happen? When people believe that the central bank would do what ever it takes to avoid a recession, they foresee expansionary monetary policy (an interest rate cut). As a result, they revise their inflation forecast upwards. This leads workers to demand higher wages as they seek to maintain their purchasing power.
Firms pass on this increased cost to consumers by increasing output prices - the wage-price spiral. Thus, a transitory shock translates into a persistent episode of inflation.
So what should the government do to ensure that the cost-push shocks do not translate into a permanent increase in inflation?
It should recognise that monetary policy makes its greatest contribution to the stability of both inflation and growth by sustaining a strategic focus on low inflation. The government should reinforce its commitment to low inflation as much as possible.
The dominant view around the world is that an independent central bank, free from political interference, is in the best position to ensure low and stable inflation over time.
Credibility of the monetary policy is crucial for anchoring inflationary expectations. Recent evidence suggests that oil prices no longer pass on to headline inflation to the same extent as they once did in countries where monetary authorities have gained credibility.
Simply announcing that price stability is the overriding objective of the policy won't do! A central bank that is burdened with other objectives like exchange rate stability cannot guarantee price stability - these goals are in direct conflict with the objective of price stability.
For example, a threat to the credibility for low inflation tends to arise if an appreciation of the exchange rate hurts export competitiveness and results in job losses. The central bank is forced to pursue expansionary monetary policy (buying US dollars in the foreign exchange market) in such a situation to prevent the domestic currency from appreciating.
This creates a doubt in the public's mind about whether the central bank can sustain domestic price stability if the pressure on exchange rate continues. The exchange rate must be allowed to adjust flexibly if a country is to enjoy the benefits that monetary policy can deliver.
Finally, current inflation is essentially pre-determined: It is a result of past policies. Transmission lags between policy actions and their effect on inflation and output monetary policy can affect only future inflation. So, the policy framework needs to be forward-looking.
Does policy making in India fulfil any of these guidelines? Unfortunately, the RBI is saddled with objectives other than inflation control and faces excessive political interference on a day-to-day basis and as a result faces a credibility deficit.
Under these circumstances, it is reasonable to think that inflation expectations in India are particularly sensitive to the possibility that monetary stimulus against the downside risk to growth might put upward pressure on inflation.
Failure to anchor inflation and inflation expectations makes a central bank susceptible to inflation scares, to which the bank must respond by tightening monetary policy aggressively, with an elevated risk of recession. This would cast a shadow on India's long-term growth outlook.
In contrast, focusing on price stability allows a central bank to avoid becoming reactive to the economy in ways that are ultimately self-defeating and instead enable the bank to manage events so as to be a stabilising force for the economy.
Vidya Mahambare is senior economist, Crisil. The views expressed here are personal
More from rediff