Effectiveness of Inflation Targeting in India – Explained, Pointwise

Introduction:

RBI adopted the Inflation Targeting on the recommendations of the Urjit Patel committee in 2016. Almost 5 years have passed since its adoption. The RBI has also announced a formal review of its inflation targeting method. Hence, there is a requirement for an elaborate review to examine the performance of this method. In this article, we will analyze the performance of Inflation Targeting in India so far. 

What is Inflation Targeting (IT)?
  1. Inflation Targeting is a method that focuses on adjusting monetary policy to achieve a specified annual rate of inflation.
  2. Types of inflation targeting:
    • Strict inflation targeting(SIT) – Under this, the central bank only focuses on keeping inflation, close to a given inflation target. 
    • Flexible inflation targeting(FIT) – Under this, apart from inflation, the central bank is also concerned about other variables like the stability of interest rates, exchange rates, output and employment ratios.
Basic Terminologies
  • Monetary Policy – It is the macroeconomic policy laid down by the central bank that focuses on the management of money supply and interest rates. 
  • Inflation – It refers to a sustained/continuous rise in the general price level of goods and services in an economy over a period of time.
  • Headline inflation – It is a measure of total inflation in an economy. In India, Consumer Price Index Combined (CPI -C) represents Headline Inflation.
  • Core inflation – It is the inflation level after subtracting the food and fuel inflation from the Headline Inflation.
  • Repo Rate – It is the rate at which RBI provides short-term loans to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
  • Shut Period – It is the period for which the securities cannot be traded
Background of Inflation Targeting
  • The Finance Act, 2016 amended the Reserve Bank of India Act, 1934 (RBI Act) . The amendment facilitated a statutory and institutionalized framework for a Monetary Policy Committee(MPC)
  • MPC was entrusted with the task of fixing the benchmark policy interest rate (repo rate) to contain inflation within the specified target level i.e. inflation targeting. 
  • A flexible inflation target (FIT) of 4% was decided with a deviation of +or-  2%. Further, headline consumer price inflation was chosen as the key indicator.
  • This agreement between the center and the RBI on inflation targeting is set to end on 31st March 2021.
Need of inflation targeting
  1. Inflation targeting advocates the objective of price stability in actual monetary policy arrangement.
  2. Adopting price stability creates a stable non-inflationary environment for resource allocation in the economy.
  3. Since the RBI sets a certain inflation rate as a goal. The central bank made people believe that prices will continue to rise. This has few advantages like, 
    • The inflation targeting benefits the economy by making people buy things in the present (before they cost more).
    • It boosts investment. As investors invest now because they are confident that the investment will give them a higher return when they sell later.
  4. A credible central bank and stable inflation lower the country’s risk premium and cost of borrowing in an open economy.
  5. It also made the RBI more accountable to the government. As the RBI needs to give a proper explanation in case it breaches the inflation targeting tolerance range (2-6%).
Performance of Inflation Targeting so far
  1. In these 5 years periods (2016-2021) after inflation targeting was introduced, RBI managed to keep inflation in control. 
    • The inflation rate has remained within the prescribed band of 2% to 6%. According to the RBI, Inflation was above 9% before the introduction of Inflation Targeting in India. 
    • Also, the RBI has been successful in anchoring inflationary expectations. As the estimated response coefficient to RBI is higher for India than it is for other countries.
      The estimated response coefficient is the relationship between the Bank response and the unexpected rise in Inflation.
  2. However, sometimes the band was breached as well. In June 2020, the upper threshold of 6% was breached due to COVID-19 lockdown.
Issues in inflation targeting
  1. Assumption of correct output level: The model of Inflation targeting is based on the assumption that inflation means overheating the economy (i.e. output or production is greater than natural level output/production.)
    • However, it is impossible to observe the level of output in an economy. Hence, setting policy rates based on the assumption that the economy is overheated, is unscientific.
  2. Limited power of RBI: The belief that RBI can successfully control inflation using Inflation targeting is not completely true. During the lockdown, food inflation peaked even when the inflationary targeting mechanism was in force. It was mainly due to supply chain disruption during the lockdown.
  3. Adverse impact on other sectors: The cases of IL&FS, PMC Bank, PNB and YES Bank suggest that poor management and maladministration in the financial sector can escape RBI scrutiny as they tend to focus more on inflation targeting.
    • RBI has kept the interest rates high to manage inflation. This has discouraged private investment thereby reducing employment and export potential.
    • High real repo rates for almost three years 2017-2019 are the primary cause of the GDP growth decline in India. The GDP declined from 8 percent (pre-IT) to 5 percent (post IT) due to high real repo rates.
  4. Global Nature of inflation: Inflation is global in nature as the price level of a good is determined by millions of producers across the world. Research by economic experts has also pointed out the international influence on the inflation level. Further, they mention points like, 
    • No one producer or one country can influence the price of any item or the general price level.
    • For instance, The average inflation rate among EM (emerging markets) targeters during 2000-04 were 4 percent, and it was 3.8 percent among the non-targeters. 
Suggestions to improve the inflation targeting
  1. The Reserve Bank of India (RBI) in its Currency and Finance (RCF) report has called for aligning the shut period with global practices. The RBI predicts that this will provide better monetary policy transmission. 
    1. Shut down period is the period, in which MPC members maintain complete silence, i.e. no media coverage. It is observed before a few days of a policy decision, till few days after the decision. It ensures no sudden volatility in the market and effective market transmission.
    2. At present the shut period is seven-day after the release of the monetary policy committee (MPC) resolution. The RBI wants to reduce this to 3 days after the resolution.
  2. In order to enhance accountability and credibility, the transcripts of the MPC meetings may be recorded. Further, the transcripts may be released in the public domain with a lag of 5-7 years.
  3. The government has to change the Inflation targeting from headline to core inflation. This will provide advantages like,
    • More than 50% basket of headline inflation comprises commodities that the RBI policy rate cannot affect. Especially fuel inflation. 
    • Food inflation is now in single digits than earlier double digits. 
  4. Improvement of Regular measurement of CPI. This includes a frequent update of the basket and its weights along with changing times.
  5. Expansion in the ambit of MPC is also needed. 
    • For instance, the inclusion of liquidity issues (liquidity adjustment facility, changes in reverse repo, and OMOs) in the discussion may result in greater transparency and effective procedures.
Conclusion

The RBI’s Currency and Finance report has indicated the central bank’s preference to maintain flexible Inflation Targeting in the range of 2-6% for the next five years. This will build confidence in the broader economy that is still prone to both supply shocks and sudden demand shrinkage. Nonetheless, some reforms are desired in the Inflation targeting procedure to achieve optimum outcomes.

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