Should RBI abandon its inflationary targeting regime?

With current CPI inflation target of 4% due for review in March 2021, there is a growing clamour to scrap the current “Flexible Inflation Targeting (FIT)” regime. Nonetheless, instead of a sole mandate of retail Inflation as nominal anchor of monetary policy, some dual mandate seems worth considering, where along with CPI headline Inflation, some other anchors such as core inflation, nominal GDP or employment can be included. Going forward, strong monetary policy transmission, institutional capacity to forecast inflation using sophisticated econometric models and independent monetary policy without fiscal dominance are perquisites for an effective FIT regime.

Inflation hurts everyone in the country from households to firms. Even moderately high inflation is bad for economy as a whole; it erodes savings and brings uncertainty to the growth and investment climate. Keeping this in mind, Inflation targeting was adopted as the primary objective of monetary policy in 2015-16 to ensure low and stable inflation in economy. Inflationary targeting as a specific monetary policy mandate offered a framework to achieve this objective in a credible and sustainable manner.

A broad consensus among experts has emerged that Inflationary targeting is quite successful in controlling inflation and anchoring inflationary expectations. However, the type of inflationary targeting regime adopted by India is “flexible” in the sense that along with fixed CPI Inflation target of 4%, RBI has adopted a tolerance band of +/-2% which gives the central bank discretion to lower the policy rates in response to shocks such as a growth slowdown in the short run while in pursuit of keeping inflation within the band.

Change in monetary policy framework: from Multiple Indicators Approach to Flexible Inflationary Targeting (FIT) Mandate

Before formal acceptance of Inflation as a nominal anchor in 2015, monetary policy in India was conducted in an ad hoc and uncertain manner without any specific mandate, i.e. RBI adopted “multiple indicators approach” where plethora of indicators such as credit, output, inflation, growth, trade balance, capital flows and exchange rate constituted the basis for formulation of monetary policy. Thus, there was no clarity about the primary objective and policy stance of RBI with apex bank adopting discretionary policies at different times.

FIT regime bringing transparency and credibility to monetary policy stance

To correct this anomaly, a Monetary Policy Framework Agreement (MPFA) was signed between the Government of India and the Reserve Bank on February 20, 2015, subsequent to which, flexible inflation targeting (FIT) regime was formally adopted with the amendment of the RBI Act in May 2016. The role of the Reserve Bank in the area of monetary policy was restated in the amended Act as follows:

“The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth”.

The adoption of Inflationary Targeting introduced accountability & transparency in monetary policy regime with added credibility and predictability to monetary policy decisions with limited possibility of speculation.

As per new FIT framework, the central bank is required to maintain 4% CPI Inflation, with a 2% tolerance band on either side, which means that inflation target band, is 2%-6%. Central bank failing to maintain Inflation within this band for three consecutive quarters, would be held accountable to Union government and  will have to explain the reasons for its failure to meet the target as well as give a time frame within which it will achieve it pursuant to timely implementation of proposed remedial actions.

Under the new framework, RBI is also required to publish the operating targets, as well as an operating procedure for the monetary policy through which the inflation target would be achieved. The apex bank is required to bring out a document every six months explaining the sources of inflation and a “forecast” for inflation for the next 6-18 months, and then forecasted inflation is compared to “target” inflation rate of 4%. The difference between the “forecast” and the “target” determines how much monetary policy has to be adjusted and the institutional arrangements to reach this target.

Dissatisfaction with FIT regime

Some experts consider FIT framework as a serious hindrance to achieving India’s goals of rapid growth and employment generation

The dissatisfaction from inflation targeting regime comes from the section of growth supporters and investors who feel that since RBI adopted inflationary targeting regime, apex bank did not cut rates easily or as much as they would like to see to support investment, credit growth and employment generation. That is, RBI did not give growth as much importance as inflation, and interest rates would have been lower if we didn’t have fixed inflationary target mandate.

Monetary policy has no effect on inflation when economy is supply constrained

For the last two consecutive quarters, CPI inflation has been above the upper limit of the tolerance band of 6% (in September and October, CPI Inflation even has been above 7%). It appears that the breach will extend to third consecutive quarter too and when it happens, it will constitute monetary policy failure and RBI will have to explain the reasons and suggest corrective measures. The rise in inflation experienced in last two quarters is clearly attributed to supply disruptions and labour shortages arisen due to local lockdowns(and certainly not due to excessive demand); the conditions which are completely out of ambit of monetary policy. Thus, it’s important that MPC differentiates between inflation caused by supply shocks and demand pull inflation while formulating policy response.

Some experts also doubt over ability of the monetary policy to influence inflation, as in Indian economy, among principal factors driving inflation are food and fuel prices, the prices of which are influenced by supply considerations and less susceptible to changes in monetary policy.

FIT framework ineffective during Stagflation phase

Indian economy has been passing through stagflationary phase since lockdown was announced in end March. As already explained, retail CPI Inflation has been above the RBI’s “upper tolerance level of 6%” for the last six months. On growth front too, GDP numbers has been into negative trajectory with Indian economy contracting by 23.9% in first quarter. In second quarter too, according to RBI estimates, economy is expected to contract by 8.6% with GDP growth expected to remain negative in remaining part of the year.

The stagflationary situation has always worried Central bank since it presents a major policy dilemma for monetarists with weak growth and high inflation pulling its decision in opposite directions. Under “Inflationary Targeting” regime in particular, any attempt by MPC to raise policy rates to control Inflation (which is actually not even demand pull Inflation; rather due to supply constraints), will hamper growth, output and employment prospects further. Such increase in policy rates during stagflation will even accentuate the Inflation burden too, as constrained growth and output will further create more supply side shocks. Thus under FIT regime, the dual forces of escalating prices and dampening growth compound each other and create a vicious circle to further deepen the growing crisis of “inflationary recession”

The proposed changes to strengthen the monetary policy framework-

Ø    Raising the inflationary target- Critics feel that 4% inflation target is too low and stiff for an emerging economy like India which is prone to supply shocks. Many economists have proposed to raise the current CPI “headline” inflation target from current 4% to a little higher target of 5%-6% to address the growth concerns. Thus, raising the inflation target by another 1%-2% will allay the fears of those who feel that keeping inflationary target at such a low level of 4% prevents RBI from cutting rates to support growth in recessionary times.

Ø  Widening the target band- Some experts opinion that the width of the India’s Inflation band at 4% (2%-6%) is too narrow, given the fact that being an emerging economy it is supply constrained which often leads to supply side Inflation. Further, remaining inside a narrow band is difficult in practice and any frequent breaches can undermine Central’s bank credibility. Thus, it is advised by some economists to widen the target band by another 1% on either side. This will not only automatically address the growth concerns, but will also relieve RBI with overburden of managing Inflation within a narrow band without any credibility breaches.

Ø  Choice of Price Index: With RBI using CPI “headline Inflation” as a nominal anchor; there is a growing clamour to include core inflation in Inflationary targeting framework- Experts have been widely divided on the issue that whether India should focus on “headline” or “core” inflation when CPI is chosen to be nominal anchor for Inflation Targeting. While headline Inflation is calculated from an all-item index, the core Inflation is calculated from a price index that excludes the highly volatile food and energy components.

As high weightage is given to food and fuel in India’s CPI basket and prices of food and fuel being highly volatile and susceptible to supply shocks (caused due to excessive monsoons & volatile movement in oil prices due to geopolitical concerns), “headline inflation” temporary can remain quite high for short periods of time, with “target” Inflation rate breaching the tolerance band. Hence, to avoid short term excessive volatility in prices, some economists demand adopting “core inflation” as a nominal anchor of monetary policy.

Ø   Dual Target of “headline” and “core” CPI inflation- Experts have also suggested incorporating a dual target of “headline” and “core” CPI inflation in Inflationary targeting framework. Thus rather, than using a single headline inflation target of 4%, a combination of 5%-6% headline inflation and a 3% core inflation target can be a new mandate for monetary policy framework.

Ø  GDP as the nominal anchor- Some economists have proposed targeting the nominal GDP. However, using nominal GDP as anchor of monetary policy has its own shortcomings as GDP measurement in India faces considerable difficulties. It will be many years before sound GDP measurement is in place, and until that is done; nominal GDP is not a credible alternative for the design of monetary policy framework.

Ø  Dual mandate of Inflation and employment- Some experts also opinion that along with inflation mandate, Central bank taking responsibility of employment, would have been a more appropriate framework. For example, Federal Reserve follows a dual mandate of price stability and maximum sustainable employment in the long run. Such a dual mandate seems to be more appropriate for an emerging economy like India, where unemployment is a major economic problem.

Has FIT achieved its stated objective?

With the completion of 5 years of FIT framework in March 2021, some critics are making the proposal to completely abandon the inflationary targeting regime, i.e. inflation rate should not be anchored at all with no Monetary Policy Committee. However, deserting FIT regime completely is a bad idea as reform has served India well with low and stable inflation achieved in recent years. The empirical evidence suggests that inflation rate based on CPI Index has come down sharply from high and volatile rate of 10%-12% before 2014 to much lower and stable rates of 4%-6% after the adoption of Inflationary targeting regime.

Further, under new monetary policy framework, repo rate has been cut sharply after adoption of FIT regime. Thus, this is in complete contrast to what growth supporters argue who believe that after adoption of FIT regime, there has been an upsurge of repo rate or an aversion to cutting policy rates in slowdown phase.

Way forward for increasing effectiveness of monetary policy transmission (MPT)

Empirical evidence suggests that RBI has taken right step towards price stability by formally adopting FIT as India’s monetary policy framework. However, a lot more needs to done for Indian economy to actually benefit from an inflation-targeting regime. Financial sector reforms for strengthening monetary policy transmission (MPT) are the first step towards this. To this end, RBI should take every measure for increasing the depth and liquidity in various segments of bond and money market. Unless financial market reforms are undertaken to strengthen MPT, small rate changes of 25 bps or 50 bps will not have any noticeable effect on aggregate demand and hence inflation.  At the same time, an adequate framework for liquidity management needs to be followed so that the operating target remains close to the policy rate.

The monetary procedure needs to be forward looking, in which policy instruments are adjusted to achieve the “target” inflation. In this regard, one of the major challenges for central banks is precise estimation of key macro- parameters, economic environment, supply shocks and any global spill-overs. Apex bank must have a well-informed view of the relative effectiveness of the various instruments of monetary policy at their disposal, improving quality of publicly available macroeconomic data, building technical and institutional capacity to forecast domestic inflation using sophisticated econometric models and estimate the time lag between the effect of monetary policy changes and their effect on inflation.

Monetary policy independence without fiscal dominance is another prerequisite for increasing effectiveness of monetary policy instruments. Monetary and fiscal policy can’t work in isolation. Any hawkish monetary policy stance to target Inflation is ineffective as long as it is not supported by adequate fiscal policy measures or at least is not made fruitless by expansionary fiscal policy. To this end, the adoption of the FIT framework also increases the responsibility of the government to maintain fiscal prudence and avoid any fiscal slippage on account of higher unproductive spending that could prove to be inflationary.

In conclusion, it can be clearly stated that Inflation targeting has been historic milestone in monetary policy institutional framework and has served Indian economy well by bringing price stability, certain growth and investment climate for investors and anchoring inflationary expectations. However, some of the proposals of raising domestic inflation target, widening of inflation band width or adopting a dual mandate where along with CPI headline Inflation, some other nominal anchors such as core inflation, employment and nominal GDP can be explored.