Baba’s Explainer – Inflation Targeting as Monetary Policy

• Inflation targeting is founded on the assumption that preserving price stability, which is achieved by managing inflation, is the greatest way to generate long-term economic growth.
• Inflation targeting allows central banks to respond to shocks to the domestic economy and focus on domestic considerations. Stable inflation reduces investor uncertainty, allows investors to predict changes in interest rates, and anchors inflation expectations.
• A major advantage of inflation targeting is that it combines elements of both “rules” and “discretion” in monetary policy. This “constrained discretion” framework combines two distinct elements:
  • a precise numerical target for inflation in the medium term
  • a response to economic shocks in the short term.
• New Zealand was the first country to embrace inflation targeting, and since then, a large number of nations, including India, have chosen it as their primary monetary policy tool.
• In India, the Monetary Policy Framework Agreement agreed between the RBI and the government in 2015 established inflation targeting.
• The RBI is mandated to maintain a rate of inflation of 4% with a 2-percentage-point deviation, i.e. inflation must be kept between 2% and 6%. If consumer inflation is more than 6% or less than 2% for three consecutive quarters, the central bank will be considered to have missed its objective.

If the central bank fails to meet its inflation target then:

• It will send a report to the government explaining why and what steps it will take to correct the problem.
• It will also have to provide an estimate of how long it will take to return to the target level.

• Autonomy with Accountability: The RBI has been given autonomy in managing the rate of inflation within the prescribed targets set by the government. If the RBI fails to keep inflation within the target range, it would be compelled to explain the reasons for its failure. Such a clause allows the RBI to have autonomy while also allowing the government to have greater accountability over the RBI’s actions.
• Greater clarity & Predictability: Inflation targeting specifies the rate of inflation that should be targeted in a given economy. With such publicly legislated aims, there is better clarity and predictability in terms of the inflation rate and monetary policy formulation.
• Promotes Growth: A high rate of inflation diminishes the buying power of the currency and eventually lowers the overall rate of GDP growth. Furthermore, a high rate of inflation is accompanied by larger levels of Fiscal and Current Account Deficits, putting the country’s macroeconomic stability at risk. As a result, a low or moderate amount of inflation would encourage investors to invest in the economy, promoting higher growth and development.
• International Best Practise: Inflation targeting has shown to be quite successful in certain advanced economies, such as the United Kingdom and New Zealand. These advanced economies have been able to keep inflation at a reasonable level for a longer period of time, resulting in enhanced macroeconomic stability.

1. Mixed Results

• During the Modi government’s first term, roughly from April 2014 to March 2019 (Modi 1.0), CPI inflation was above 6% only in 6 out of 60 months.
  • Moreover, 5 of those 6 months were in 2014, well before the RBI Act was amended to provide a statutory basis for inflation targeting.
• One can say that the framework of inflation targeting and central bank “independence with accountability” worked well during Modi 1.0
• However, actual year-on-year inflation in 2022 has ruled above 6% every single month from January to August. If it does so in September as well, the RBI, under section 45ZN of the same law, will have to submit a report to the Centre on “the reasons for failure to achieve the inflation target” and “remedial actions proposed to be taken by the Bank”.
• In the 41 months from April 2019, inflation has exceeded 6% in as many as 21. In other words, a failure rate of over 50% in Modi-II era.
• Things have been different in Modi 2.0. The last two years or less have seen a resurgence of inflation.

2. Inefficiency of Monetary Policy tools

• There’s a simple reason for the RBI’s “failure” to adhere to its inflation-targeting mandate. It has to do with food and beverage items, which have a combined 45.86% weight in the overall CPI. Inflation led by rising prices of food stuff cannot quickly or easily be contained by the mode of control which RBI uses.
  • During Modi 1.0 (2014-19), food inflation was lower than general inflation in 38 out of the 60 months. During Modi 2.0 (2019 onwards), the average CFPI inflation (Food Inflation) is at 6.3%, more than the 5.7% for general inflation.
• Also, the transmission of Monetary Policy Is Inadequate in India. Inflation targeting is better suited to mature economies since monetary policy transmission is more efficient in these countries. However, in India, the transmission of monetary policy is inefficient, which can impair the efficiency of inflation targeting.

3. Monetary Dependence

• Monetary policy independence basically refers to the central bank being insulated from government interference or electoral pressure in setting its interest rates with a view to achieving low and stable inflation.
• The preponderant weight of food items in the Indian consumption basket is high as compared to that in developed countries and therefore, RBI is forced to rely more on government action to meet inflation targets.
• Far from acting independently, RBI has to depend on “supply-side” measures by the government to curb this food inflation. That translates into monetary dependence, not independence.
• To get an idea of the government’s supply-side actions that have made the RBI’s job easier, consider the following:
  • In the last one year, the effective import duty on crude and refined palm oil has come down from 30.25% and 41.25% to 5.5% and 13.75%, respectively. It’s been even sharper — from 30.25% to nil — for crude soyabean and sunflower oil
  • On May 13, 2022, the government banned exports of wheat. This was extended to wheat flour — including atta, maida and rava/ sooji (semolina) — on August 27, 2022.
  • On September 8, exports of broken rice were prohibited. Besides, a 20% duty was imposed on shipments of all other non-parboiled non-basmati rice.
  • In all the above instances the government is trying to increase the supply of food items in domestic market so as to ease the price rise

4. Diverted Focus

• RBI’s responsibility to regulate the financial sector may have taken a back seat after adoption of inflation targeting as the main objective. Some of the crisis in financial sector which is partly attributed to short comings in regulations are:
  • Within three years of adoption of inflation targeting as goal, a crisis engulfed IL&FS– It defaulted on several of its obligations, including repayment of bank loans and the redemption of commercial paper
  • Punjab and Maharashtra Co-operative Bank- fictitious accounts created and deposits were siphoned off as loans to the promoters.
• At the global level, the 2008 Global Financial Crisis demonstrated that price stability alone does not guarantee financial stability and that a central bank’s excessive reliance on price stability may lead to the neglect of other critical functions such as regulation, resulting in an economic crisis.
• Former RBI Governor Subbarao has stated that there is a trade-off between pricing stability and financial stability and that the more successful a central bank is at maintaining price stability, the more likely it is to jeopardize financial stability.

5. Disregards the RBI’s multifaceted role:

• It is impractical for a central bank in a developing country like India to focus just on inflation without considering the greater development context. The Reserve Bank of India (RBI) must strike a balance between growth, price stability, and financial stability.