Inflation Targeting

Inflation targeting is a method of controlling the rising prices in an economy. It explains the two ultimate goals of the central bank's monetary policy - to maintain price stability and ensure economic growth. Once the inflation target is set, the central bank exercises its monetary policy tools to keep the inflation fixed around the targeted figure.

Until 2014, in its monetary policy framework, RBI focused on multiple indicators like Growth, Inflation, Employment, and Exchange Rate.

But, the Urjit Patel Committee on Monetary Policy highlighted certain drawbacks of such an approach. The multiple indicators approach has no nominal anchors and defined targets that can be objectively measured and the policy framing authority held accountable.

Also, often the different targets are in contradiction to each other. For example, to boost growth RBI might lower bank rates. But this could lead to a rise in inflation.

Another condition could be the one involving exchange rate. To boost exports RBI might lower the exchange rate, but it will lead to inflationary pressures due to costly imports.

Therefore, the multiple-indicator approach to Monetary Policy had certain drawbacks and needed to be reformed.

The Urjit Patel Committee, going by international standards, recommended that the RBI should focus only on Inflation Targeting as the objective of the Monetary Policy. Persistent high inflation lowers the demand thereby affecting production and hence growth in the economy. High inflation also lowers the real interest rates thereby lowering financial savings and hence reducing investible capital in economy which leads to poor growth.  

High inflation by lowering real interest rates pushes public preference towards physical savings like gold. This leads to increased CAD which in turn leads to weaker rupee and inflation due to costly imports (crude mainly as it affects all other commodities).

Therefore, targeting inflation will automatically check other indicators like growth, exchange rate etc.

Inflation Targeting framework-

• RBI to choose CPI (combined) as the nominal anchor.
• Inflation target should be of 4% with a band of ±2%.

In case of failure to achieve the targets the RBI as to give a public statement detailing the reasons for failure along with framework for future corrections and a time limit to achieve the desired targets.

But this approach has certain drawbacks the most evident of which is that inflation in India in recent years has been led by food and fuel and there is little that monetary policy can do to check these.

For this there should be close cooperation and coordination between government and RBI so that the inflation targets are achieved easily. On its part the government must focus on certain issues like –

• Moderate wage growth in MNREGA so as to check demand side pulls on inflation.
• Rationalize the MSP so that there is no supply-side inflation in food.
• Lower Fiscal Deficit because a high Fiscal deficit leads to either deficit financing or borrowing both of which are not good for the economy. (Poor fiscal health leads to poor ratings by international organizations which leads to poor FDI/FII/ECB inflows and weakens the rupee causing further inflation).

Advantages and Disadvantages of Inflation Targeting

Advantages

1. Stabilizes the rate of inflation and prevents the economy from overheating;
2. Enables businesses, investors, and government to plan their investments and policies considering the inflation rate;
3. Helps maintain a transparent monetary policy;
4. Enables increased economic stability 

Disadvantages

1. Too much focus on price levels and money supply-related goals ignores other important aspects of economic growth and unemployment;
2. It cannot address the problem caused by external shocks, so fails to stabilize the exchange rate in the short run;
3. It addresses only the demand-side cause of inflation and fails to remove supply bottlenecks or shortages;
4. It fails to limit policy flexibility or constrain policy measures such as fiscal stimulus

Evaluation of Inflation Targeting in India

Though currently, the inflation rate in the Indian economy is higher than the targeted one. Various reasons behind the current high rate of inflation are

• spike in crude oil prices in the international market 
• increase in commodity prices due to disruption in supply chains after the start of the Russia-Ukraine conflict
• fall in wheat production in the year 2022 due to climatic reasons

But overall, since the beginning of inflation-targeting in India in 2016, the average inflation measured through the GDP Deflator has declined significantly. The average inflation rate which was 5.69 during the five years in the pre-inflation targeting period, declined to 3.47% in the five-year period between 2016-21. This fall in inflation is the highest among both inflation-targeting countries as well as those that did not adopt it. Though softening of international commodity prices and domestic food prices also contributed to it besides moderation in minimum support prices.

During the period of 2016-21, India achieved a substantial fall in inflation volatility also. The average inflation volatility which was 7.93% five years before inflation targeting has declined to 0.89% during the inflation targeting regime. The fall in volatility remained the highest compared to Indonesia, Thailand, the Philippines, and Korea. Even the real GDP growth did not decline during this period. The five-year average real growth rate which was 6.50 % during 2011-15, increased marginally to 6.63% during 2016-19.

Even monetary policy transparency in India has improved after the adoption of the inflation-targeting framework. The Inflation Expectations Survey of Households shows that the inflation expectation has been forward-looking in the post-inflation targeting period in India. Inflation expectations, now, do not depend much on past information. The lagged impact of past inflation expectations on current inflation expectations was significantly higher before the adoption of inflation targeting, but that lagged dependency has fallen in the flexible inflation targeting regime. Households are increasingly using current and future information to form inflation expectations. This implies that transparency in monetary policy is helping to reduce inflation expectations.

Overall, inflation targeting in India has been a success story. RBI has rightly earned goodwill in this respect. Therefore, it is better for India to keep continue with the flexible inflation targeting regime.

Monetary Policy Committee

Until 2014, RBI has been the sole authority on matters pertaining to Monetary Policy. But then, the government expressed its desire to be a part of the monetary policy formulation and review exercise. Even in the past several committees like Tarapore committee, FSLRC, Urjit Patel committee have recommended for constitution of a Monetary Policy Committee comprising of representatives from both RBI as well as Government of India. Several countries (like England) have such committees.

Generally the Central Banks across the world are independent authorities on Monetary Policy. This is so because, governments in order to fulfil the populist agendas during their term might modify the monetary policy so as to attain these short term objectives but causing harm in the long run. For eexample, to boost growth during their term, the Government might lower the interest rates and increase the money supply in economy. But in the long run it might lead to inflationary pressures. Therefore it is the central banks which decide upon the monetary policy in most major economies. But becasue the governments have some election agendas, some planned development targets and welfare objectives to fulfil for which they need to effect certain changes in the monetary policy framework. Therefore, governments want say in deciding the monetary policy.

Also, since the RBI had adopted Inflation Targeting as the central objective of Monetary Policy, the role of government had become imperative because inflation in India is mostly led by Food and Fuel and could not be dealt by monetary policy alone and needs government action (like moderating wage growth rate, rationalizing MSPs etc.).

Therefore, a 6-member Monetary Policy Committee was set up (3 members from RBI side and 3 from the government side) under Section 45 ZB of the amended RBI Act, 1934.To ensure its independent functioning the discussions and the decisions of the committee must be put in the public domain.