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Several commentators have raised questions recently, ahead of an official review of the monetary policy framework on whether India should modify its inflation targeting (IT) framework, or even abandon it.
Inflation Targeting (IT) is a monetary policy that involves a central bank setting a target for inflation and adjusting interest rates to achieve that target.
The IT was implemented in response to high inflation during 2009-2012 when inflation reached 15%.
The Finance Act of 2016 amended the Reserve Bank of India Act to identify price stability as the primary objective of monetary policy, and to adopt flexible inflation targeting as the nominal anchor for monetary policy.
The law also established a six-member monetary policy committee with responsibility for achieving the inflation objective.
In August 2016, the government announced a CPI(Consumer Price Index) inflation target of
4 percent, with 6 per cent and 2 per cent as the upper and lower tolerance levels.
Therefore the current inflation target is 4 percent point, +/- 2 percentage point tolerance band.
Food prices make up 46% of the CPI, which challenges inflation targeting. They are sensitive to supply shocks and government interventions.
This leads to discrepancies between headline and core inflation. Rising food prices have outpaced other prices and this has again affected policy effectiveness.
Note: On the recommendation of the Urjit Patel Committee (2014), the RBI adopted CPI as the index to measure inflation. Earlier, RBI had given more weightage to WPI(Wholesale price index) as the key measure of inflation for all policy purposes.
Food prices are a major part of the cost of living for a large portion of the population in India. However, food prices are volatile and have been rising for over a decade, but the headline inflation which includes food items has not increased at the same pace as food inflation, which indicates a structural problem.
Headline inflation
This is the total inflation rate in an economy, including the prices of commodities like food and energy. Headline inflation is reported in relation to the Consumer Price Index (CPI), which calculates inflation by tracking the prices of a fixed basket of goods. Core inflationIt removes the CPI components that can exhibit large amounts of volatility from month to month such as food and beverages. In July, the Economic Survey for 2023-24 suggested excluding food prices from India's inflation-targeting framework. Excluding food from the inflation target leaves India vulnerable to rising food costs. Read more here: https://www.iasgyan.in/ig-uploads/pdf/info_different_inflations.pdf |
Weaknesses India's monetary policy transmission faces major issues. Interest rate changes do not quickly impact bank lending costs. Banks do not immediately transmit the policy rates decided by RBI.
The RBI struggles to build credibility as there was lack of historical focus on price stability. Public perception is influenced by past inflation issues.
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.
The RBI has effectively maintained inflation within the 4-6% target range and avoided double-digit inflation even amidst various shocks such as the Covid-19 pandemic.
Price stability has led to economic growth and reduced interest rates, which has created better economic outcomes in terms of investment and employment in the economy.
Inflation-forecast targeting should be realistic as it helps mitigate supply shock effects. Achieving targets builds central bank credibility. Publishing realistic forecasts enhances public confidence and allows for flexible responses to new developments.
There is a need to strengthen the RBI's analytical capabilities and data accuracy, which is essential for better inflation and growth forecasts, particularly concerning agricultural issues.
Given that the Inflation targeting framework is still developing, any modifications should be incremental to avoid a negative impact on the established goal of price stability.
Important articles for refrence
Role of RBI in controlling the inflation
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PRACTICE QUESTION Q.In the context of recent criticisms of the inflation targeting framework adopted by India since 2016, discuss the challenges in the present framework, and the implications of potential modifications to this framework.( 250 words). |
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