- GS-3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.
- GS-3: Monetary Policy
Government on Inflation Targets
Context: On the last day of the financial year 2020-21, the Finance Ministry announced that the inflation target for the five years between April 2021 and March 2026 will remain unchanged at 4%, with an upper tolerance level of 6% and a lower tolerance level of 2%
This is the retail inflation target that will drive the country’s monetary policy framework and influence its decision to raise, hold or lower interest rates.
Why is this important?
- India had switched to an inflation target-based monetary policy framework in 2015, with the 4% target kicking in from 2016-17.
- Many developed countries had adopted an inflation-rate focus as an anchor for policy formulation for interest rates rather than past fixations with metrics like the currency exchange rate or controlling money supply growth. Emerging economies have also been gradually adopting this approach.
- In adopting a target for a period of five years, the central bank has the visibility and the time to smoothly alter and adjust its policies in order to attain the targeted inflation levels over the medium term, rather than seek to achieve it every month.
Analysis of Government’s targets
- Worrying Trend: Volatile food prices and rising oil prices had already driven India’s consumer price index (CPI)-based inflation past the 6% tolerance threshold several times in 2020. Retail inflation has remained below 6% since December 2020. However, it accelerated from 4.1% in January 2021 to 5% in February 2021. Core CPI inflation also increased to a 78-month high of 6.1% in February 2021.
- Pressure of Oil Prices: With oil prices staying high inflation headwinds remain.
- Growth Vs Inflation: There was some speculation that the Central government, whose topmost priority now is to revive growth in the COVID-19 pandemic-battered economy, may ease up on the inflation target by a percentage point or two. This would have given RBI more room to cut interest rates even if inflation was a tad higher.
- Welcome Step: That the government has desisted from doing this and left the inflation target untouched has been welcomed by economists who believe that the new framework has worked reasonably well in keeping inflation in check over the last five years. They attribute the few recent instances when the upper target was breached to the exceptional nature of the COVID-19 shock.
What is the RBI’s position on this?
- The RBI had, in recent months, sought a continuance of the 4% target with the flexible tolerance limits of 2%.
- The 6% upper limit, it argued, is consistent with global experience in countries that have a large share of food items in their consumer price inflation indices.
- Accepting inflation levels beyond 6% would hurt the country’s growth prospects, the central bank had asserted.
How are consumers impacted by this?
- Suppose the inflation target were to be raised to 5% with a 2% tolerance band above and below it, for consumers, that would have meant that the central bank’s monetary policy and the government’s fiscal stance may not have necessarily reacted to arrest inflation pressures even if retail price rise trends would shoot past 6%.
- For instance, the central bank has been perhaps the only major national institution to have made a pitch for both the Centre and the States to cut the high taxes they levy on fuels that have led to pump prices for petrol crossing ₹100 a litre in some districts.
- As high oil prices spur retail inflation higher, the central bank is unhappy as its own credibility comes under a cloud if the target is breached.
- If the upper threshold for the inflation target were raised to 7%, the central bank may not have felt the need to seek tax cuts (yet).
- Thus, the inflation target makes the central bank a perennial champion for consumers vis-à-vis fiscal policies that, directly or indirectly, drive retail prices up.
Connecting the dots: