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Inflation Targeting
Context: The Reserve Bank of India (RBI) is undertaking a crucial five-year review of its monetary policy framework, sparking a significant public debate. At the heart of this review is the efficacy of the Inflation Targeting (IT) regime, adopted in 2016, which has been a cornerstone of India’s economic policy.
What is Inflation Targeting?
- Inflation Targeting is a modern monetary policy framework where a central bank publicly announces a specific, numerical inflation rate as its primary goal.
- The central bank then uses its main policy instrument, typically the short-term interest rate, to steer actual inflation towards this publicly declared target.
- Objective: The primary objective is to achieve price stability. By providing a clear and transparent goal, it aims to “anchor” the public’s expectations about future inflation.
- Mechanism: If inflation is forecast to be above the target, the central bank raises interest rates to cool down the economy by making borrowing more expensive.
- Conversely, if inflation is below target or economic growth is faltering, it may cut rates to stimulate spending and investment.
- Global Adoption: Pioneered by New Zealand and Canada in the 1990s, this framework is now used by approximately 45 countries and the Eurozone.
Why is it Necessary?
- Transparency and Credibility: It makes the central bank’s actions predictable and holds it accountable to a clear, measurable standard.
- Anchoring Expectations: When businesses, investors, and households are confident that inflation will remain low and stable, they make long-term plans (like investments and wage contracts) without fearing eroding purchasing power. This reduces economic volatility.
- Flexible Discretion: Most regimes, including India’s, practice Flexible Inflation Targeting (FIT).
- This allows the central bank to balance its primary goal of price stability with secondary objectives like supporting economic growth and employment, especially during economic shocks like a recession.
How is Inflation Targeting Done in India?
India formally adopted the Flexible Inflation Targeting framework in 2016 through an amendment to the RBI Act:
- Target: The target is set at 4% headline CPI (Combined) inflation.
- Tolerance Band: A range of ±2 percentage points (i.e., 2% to 6%) is provided, allowing the RBI flexibility to address growth concerns when needed.
- Governing Body: A six-member Monetary Policy Committee (MPC) is entrusted with the responsibility of setting the policy repo rate to achieve this inflation target.
- Performance: Since its adoption, India’s average inflation has been 4.9%, a significant improvement from the 6.8% average in the preceding years.
- Current Debate: A key issue is the relevance of the current CPI basket, which is based on 2012 consumption patterns.
- The RBI has initiated a discussion to update it to include more services (telecom, digital payments, healthcare) and better reflect modern consumption habits.
- The Great Food Debate: A central tension in India’s IT framework is whether to target headline CPI (which includes food and fuel) or core CPI (which excludes them).
- RBI’s stance (pro-headline): Headline inflation is what citizens experience directly.
- Targeting it helps anchor public expectations and builds credibility. Furthermore, food-fuel shocks can spill over into core inflation via wages and transport costs.
- Critics’ stance (pro-core): Food and fuel prices are highly volatile and driven by supply-side factors (monsoons, global oil prices) beyond the RBI’s control.
- Targeting core inflation, which reflects underlying demand pressures, could prevent policy overreactions to temporary supply shocks.
What More Can Be Done to Address Inflation?
While the IT framework is powerful, it can be complemented by other measures and insights from global practices:
- Modernise the CPI Basket: As planned, urgently updating the CPI basket weights and components to reflect current consumption patterns is essential for accurate measurement.
- Dual Focus (The Fed Model): Like the U.S. Federal Reserve, which primarily tracks the headline Personal Consumption Expenditures (PCE) index but pays extremely close attention to core PCE for underlying trends, the RBI could institutionalise a dual-track analysis.
- Strengthen Supply-Side Management: Monetary policy is a blunt tool for supply-shock driven inflation. The government must play a more active role through:
- Agricultural Reforms: Strengthening supply chains (e.g., through Operation Greens) to reduce the volatility of food prices.
- Strategic Buffers: Maintaining strategic reserves for key commodities like pulses, onions, and edible oils to intervene in the market during price spikes.
- Trade Policies: Using timely import-export measures to manage domestic availability.
- Clear Communication (Forward Guidance): Enhancing the clarity and effectiveness of the MPC’s communication to further solidify inflation expectations among the public.
- Review the Target Band: While a radical shift may not be needed, the review could consider if the 2-6% tolerance band remains optimal for India’s growth-inflation dynamics.
