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Alternatives to Inflation Targeting

Synopsis: Many economists are criticizing the RBI’s role in inflation targeting. They are suggesting alternatives to inflation targeting. Let’s have a look at them.

Background
  1. The central government confirmed the continuance of inflation targeting as a tool to monitor inflation within the same bandwidth.
  2. The “inflation targeting” regime came into force in 2016. Recently inflation targeting has been renewed for another five years.
  3. Following this, the RBI will continue to target maintaining retail inflation within the band of 2% to 6%.
  4. RBI will use the headline inflation to control the inflation as it reflects the prices of essential consumer goods.
  5. Retail core inflation, is the inflation rate without taking into account the fluctuations in the prices of fuel and food items.
Why many people have criticised RBI’s role in inflation targeting?

Many have criticised the RBI’s mandate of inflation targeting because of its contradictory role.

  • RBI acts as a regulator to maintain financial stability and control prices in the economy by increasing interest rates. But this has a negative consequence on economic growth.
  • Also, RBI is responsible to boost the economy by reducing repo rates. Because Cheaper loans will make it easier for firms and governments to borrow and spend/invest thus leading to economic growth.
  • Between 2016 and 2020, many times RBI focused more on keeping retail inflation low by setting high interest. This has affected India’s economic growth.
Alternative suggestions to inflation targeting:
  1. First, instead of headline retail inflation, the RBI should focus on the retail core inflation rate. Because fuel and food prices often shoot up in the short-term due to supply disruption.
  2. Second, RBI should not be looking at retail inflation. Instead, it should look at wholesale inflation. Because RBI’s move to tweak interest rate affects the credit available to businesses. This, in turn, is affected by wholesale inflation, and not retail inflation.
  3. Third, RBI should neither use the wholesale nor retail inflation rate as targets. Instead, the RBI should create a Producer Price Index to suit the RBI’s need.
  4. Fourth, a singular focus on maintaining price stability will be counter-productive for a developing economy such as India. They argue that the RBI should be working with the government towards ensuring fast economic growth rather than focusing on inflation targeting. Their argument is that inflation targeting is not the only way to be prudent about macro-financial stability.
Why RBI should continue Inflation targeting?

There are many benefits associated with Inflation Targeting. They are,

  1. First, a high inflation rate is the most regressive kind of tax. The poorest people suffer the most. By targeting inflation India can avoid hurting poor people.
  2. Second, as NPA’s or bad loans are being recognised by banks, macro-financial stability will come into sharp focus. Inflation targeting can provide such macro-financial stability.
  3. Third, Inflation targeting also takes care of supply-side bottlenecks.  For example, India’s inflation rate remains somewhat constant despite the increasing fuel prices and Covid-induced lockdowns in India.

But, Under the given circumstances, it is a wise decision by the government to allow RBI to focus on targeting retail inflation. This will ensure that India’s poorest, who are the most hit by the pandemic will not be affected further.

Source: Indian Express

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