Inflation targeting in India — what are the features and why it is controversial?

The Government has just made a formal ratification to the induction of inflation targeting (IT) in India. Previously, the Finance Minister announced the introduction of IT in his budget statement 2016. Similarly, the Government and the RBI got a memorandum of understanding about the cooperative policies they have to adopt while adopting inflation targeting.

What is inflation targeting?

Now the question is what is inflation targeting. Similarly, what changes it will bring in the conduct of RBI’s monetary policy.

Technically, inflation targeting is a type of monetary policy framework. A Monetary Policy Framework shows how a central bank’s policy instrument (like repo) works in the economy to influence (hit) a target (like inflation). The main features of inflation targeting framework are:

  • Single target: inflation
  • Single instrument used by the central bank: short term interest rate (repo)
  • Single objective: Price Stability.

Inflation targeting was introduced after the suggestion made by the Urjit Patel Committee. Following are the main features of the inflation targeting regime introduced in India.

1. Determination and notification of the Annual Inflation Target

As per the RBI Act, 1934, the Central Government, in consultation with RBI, fixes an annual inflation target in every five years. The inflation target will be based on headline CPI inflation (combined CPI prepared by the CSO). The set target would be notified in the Official Gazette.

While setting the above target, inflation targeting in India will consider the growth dimensions also.

 “The key advantage of a range around a target is that it allows MPC to recognize the short run trade-offs between inflation and growth but enables it to pursue the inflation target in long run over the course of business cycle.”

Inflation Target for 2016-21

The annual inflation target for the period beginning from August 5, 2016 and ending on the March 31, 2021, is set as under:

  • Inflation Target: Four per cent.
  • Upper tolerance level: Six per cent.
  • Lower tolerance level: Two per cent.

This means that the annual inflation target is 4% with an upper tolerance level of 6% and lower tolerance level of 2%);

  1. Flexibility in inflation targeting

The inflation targeting regime gives flexibility in meeting the inflation target with a 2% band for the period 2016-21:

  • upper tolerance limit of 6% and
  • lower tolerance limit of 2%
  1. Repo as the policy rate

The RBI can target inflation primarily by changing the ‘Policy Rate’ (short term interest rate) of Repo. This  means that the repo rate will be the anchor policy rate in meeting the inflation target.

4. The Monetary Policy Committee

The MPC would be entrusted with the task of fixing the policy rate (repo rate) required to contain inflation within the specified target level. Monetary Policy Committee (MPC) can be described as the ‘governing body’ on monetary policy decisions. The MPC should meet at least four times in an year.

The MPC will ha six members – three from the RBI, and three appointed by the government. The Governor will be the Chairman of the MPC and he will have a casting vote. Decisions are taken on the basis of majority vote.

What is Monetary Policy Committee (MPC)?

5. What is the condition for a failed inflation target?

An important element of the new framework is the interpretation of failure of inflation target and the launch time for correction measures. As per the policy, if inflation goes above 6% or goes below 2% for three consecutive quarters, then it will be treated as the failure of the target. Counteractive measures should be initiated in such a scenario.

6. What the RBI to do if the inflation target is not met?

The new notification also prescribes the procedure to be followed by the RBI if the target is missed. “Where RBI fails to meet the inflation target, it shall set out a report to the Central Government stating the reasons for failure to achieve the inflation target; remedial actions proposed to be taken by RBI; and an estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions.”

7. What is the time period for a set target?

The Central Government, in consultation with the RBI, determines the inflation target in terms of the Consumer Price Index (CPI), once in every five years. This target would be notified in the Official Gazette. The current target will end on March 31, 2021.

Why inflation targeting is controversial?

A unique and at the same time a controversial feature inflation targeting is that the central bank should sideline all other objectives to ensure that the single goal of price stability is realized. This strategy makes the IT framework generally unacceptable in the developing world. This is because there are two problems while a developing country central bank adopt it.

First, fighting inflation or price stability is one important objective of the general macroeconomic objective in fast growing developing economies. The equally important objective is achievement faster economic growth. Second one is that generally there is conflict or trade-off between the objective of price stability and economic growth. Another limitation of inflation targeting in countries like India, it neglects the real cause of inflation – agricultural supply shocks which can’t be solved by any monetary policy action.

(A good argument was elaborated by Pulpare Balakrishnan in his article: Retrofitting the Reserve Bank” – the Hindu, Editorial, August 6, 2016.)

There is intense debate about the suitability of inflation targeting in developing economies on the one hand and on the other many economists argue that after the global financial crisis, inflation targeting has lost much of its relevance. A negative side of inflation targeting as a philosophy is that it openly accepts reduction of economic growth as a way to achieve price stability. But growth is as important as price stability.

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