Relevance of Inflation Targeting in India

Synopsis: Inflation control will always be relevant. But there is no conclusive evidence that the policy of inflation targeting has worked in India.

Background
  • The RBI was tasked with a mandate of the inflation target of 4 percent with a 2% deviation either way in June 2016. This agreement between the centre and the RBI is set to end by march-31-2020.
  • It has been acknowledged that in these 5 years period (2016-2021) after inflation targeting was introduced,
      • Inflation rate has remained within the prescribed band of 2% to 6%.
      • Also, the RBI has been successful in anchoring inflationary expectations.
  • Against this backdrop, this article evaluates the success of inflation targeting as an effective monetary policy in India.
What is inflationary targeting?
  • Inflation targeting prescribes the use of the interest rate to target inflation. Whereas other methods to control inflation targets money-supply (monetarist approach). For example, Open Market operations.
  • Some suggest inflationary targeting is more effective than the monetarist approach, as the policy interest rate, is under the direct control of the central bank.
What are the issues in Inflation targeting?

First, inflation targeting is not statistically validated for Indian data.

      • The model of Inflation targeting is based on the assumption that inflation means overheating the economy. i.e., increased output greater than natural level output.
      • So, the Central bank will recommend raising the rate of interest (repo rate). This will eventually reduce the money supply in the economy and normalize economic activity, thereby achieving a reduction in inflation levels.
      • However, it is impossible to observe the level of output in an economy. Hence, setting policy rates based on the assumption that the economy has overheated is unscientific.

Second, the belief that RBI can successfully control inflation using Inflation targeting is not completely true. Consider the following examples,

      • First, RBI data on household expectations showed that inflation will remain well above 6% up to 2020.
      • However, inflation had fallen steadily since 2011-12, halving by 2015-16. During this period inflation targeting was not introduced. So, this explains that there are other factors that control inflation.
      • Second, during lockdown food inflation peaked even when the inflationary targeting mechanism was in force. It was mainly due to supply chain disruption during the lockdown.
      • Also, the lockdown period witnessed a contraction in growth but coincided with inflation. This is against the core principle of inflation targeting that inflation denotes overheating economy.
  • Third, if the inflation in India has been controlled via inflation targeting in the past five years, it would have benefitted growth, exports, non-performing assets (NPAs) of commercial banks, and employment.
      • However, the result has not been on the expected lines. Only, private investment has declined as higher interest rates contributed to a declining private investment rate.
      • Other factors employment and exports are declining steadily.
      • Also, NPA’s are increasing since 2016. 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.

Source: The Hindu

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