Flexible Inflation Targeting

What does Inflation Targeting mean?

Inflation Targeting is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation. The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation.

Types of Inflation Targeting

Strict inflation targeting is adopted when the central bank is only concerned about keeping inflation as close to a given inflation target as possible, and nothing else.

Flexible inflation targeting is adopted when the central bank is to some extent also concerned about other things, for instance, the stability of interest rates, exchange rates, output, and employment.

Background

India formally adopted flexible-inflation targeting (FIT) in June 2016 to place price stability, defined in terms of a target CPI inflation, as the primary objective of the monetary policy. In this context, it draws on Indian macro-economic developments since 2000 and the experience of other countries that adopted FIT to bring out insights on how credible policy with an emphasis on strong nominal anchor can reduce the impact of supply shocks and improve macroeconomic stability. For illustrating the key issues given the unique structural characteristics of India and the policy options under a FIT framework, the paper describes an analytical framework using the core Quarterly Projection Model (QPM). Simulation of QPM is carried out to illustrate the monetary policy responses under different types of uncertainty and to bring out the importance of gaining credibility for improving monetary policy efficacy.

The Reserve Bank of India Act, 1934 was amended to provide a statutory basis for an FTI framework. The amended Act provides for the inflation target to be set by the Government, in consultation with the RBI, once every five years. India adopted flexible inflation targeting mandate of 4% with (+/-2%) as tolerance band and headline Consumer price Inflation was chosen as a key indicator.

So, What’s in the news??

The Central Bank of India aka Reserve Bank of India (RBI) has proposed to the Government of India (GOI) to continue with the current inflation-targeting framework that is 4% with (+/- 2%) as tolerance band, for the next 5 year as well that is 2021 to 2026. 

The theme of the Report is “Reviewing the Monetary Policy Framework" which assumes topical relevance in the context of the review of the inflation target by March 2021 against the backdrop of structural changes in the macroeconomic and financial landscape that have prompted several central banks to undertake policy framework reviews. Finance Minister Nirmala Sitharaman had earlier stated that the government would review the inflation target band as the five-year term for the Monetary Policy Committee (MPC) is coming to an end. RBI has the mandate to keep retail inflation at 4 percent with a bias of plus/minus 2 percent on either side. The six-member MPC, headed by the RBI Governor, decides on the monetary policy keeping in mind this inflation target band.(Hawkish, Accommodative, and Dovish Stance)

How does the Interest Rates are decided by MPC, based on CPI?

For the past few weeks; the Crude oil Price is rising, due to a curb in its supply. Now, the impact of this on the Supply chain would be passed to the customer as the price of other commodities will rise too. The CPI for February 2021 is 5.03%. So, to keep the price in control, the MPC of RBI might have a Hawkish Stance (Increasing the Interest rate). By hawkish stance, MPC will curb the liquidity in the market. Due to which price will come down by some percentage.

Now, we have understood that Hawkish Stance is taken by MPC when there is more Liquidity in the economic system due to which price rises (inflation). Likewise, Dovish Stance is taken when there is less or low Liquidity in the economic system due to which price Falls (Deflation).

Criticism on the FIT Framework

The RBI has by and large been successful in keeping inflation within the mandated 2%-6% range. But the flexible inflation targeting policy has faced criticism recently on account of the high weighting given to food items in the inflation basket which have proven highly volatile. CPI inflation on average has stayed above the RBI's mandated range in recent months due to supply-side disruptions on account of a nationwide lockdown to contain the coronavirus pandemic. And despite having spent less in relative terms than other emerging markets on direct fiscal stimulus to counter the pandemic-driven downturn, India faces a bulging fiscal deficit and a steep rise in its debt-to-GDP ratio. India's GDP contracted 23.9% in the June quarter and is seen contracting. Some economists have said the inflation targeting framework has harmed growth due to its narrow focus on inflation compared with the multiple-indicator approach the RBI previously used, which looked at both growth and price stability.

Some economists have said the inflation targeting framework has harmed growth due to its narrow focus on inflation compared with the multiple-indicator approach the RBI previously used, which looked at both growth and price stability. “A case can be made that India has been a precocious inflation targeter,” V. Anantha Nageshwaran, a member of the Prime Minister’s Economic Advisory Council wrote in an opinion piece for the Mint newspaper in August. “The country may have sacrificed financial stability and economic growth in the process. So, India may need to re-examine the appropriateness of the IT (inflation targeting) framework for its development needs,” said Nageshwaran.

History and MPC

The Monetary policy framework can be divided into 4 phases

Interdependence to 1985: Pre-Monetary Targeting

1986 to 1997: Monetary (Money Supply) Targeting

1998 to 2015: Multiple Indicator Approach

2016 to 2021: Flexible Inflation Targeting

The ultimate goals of monetary policy are stable growth and moderate inflation. However, these goals cannot be directly controlled. Given this, central banks (CBs) specify intermediate targets that they can control and are related to these goals. Over the past three decades, Central Banks have experimented with three nominal targets: exchange rates, money supply, and inflation.

 

 A credible exchange rate target, such as a currency board, can lower domestic inflation to the anchor currency, which is characterized by low and stable inflation (usually the USA). However, the downsides include loss of monetary policy independence and fragilities such as asset-price inflation.

 

 

A money-supply target is easily understood and promotes accountability. The downside here is that the demand function for money is not stable, consequently, the relationship between money supply and inflation has broken down.

 

 

In inflation targeting (IT), RBI follows rules such as the Taylor Rule to set interest rates by reducing the deviation between an inflation forecast and the inflation target to zero over a target horizon. The rationale for inflation targeting is that a discretionary monetary policy setting leads to higher long-run inflation without corresponding gains in growth. More than 20 central banks have adopted inflation targeting as their basic framework.

 

The RBI had indicated that it will condition the evolution of inflation to a 5% level by March 2014. In the post-policy press conference, it was denied that this was a move towards inflation targeting. In most countries, inflation targeting was introduced when inflation was trending lower and contributed to building the credibility of the monetary mechanism. A similar setting could now emerge here and would be a great opportunity for a soft launch of inflation targeting Framework.

The reluctance in adopting inflation targeting in India is on account of the following:

 

 i. The policy rate does not have a significant effect on inflation. It needs to be mentioned that monetary policy transmission does work when the banking sector is in a liquidity deficit.

ii. The reaction function of the RBI is stronger to the exchange rate rather than inflation. In the recent monetary policy, RBI warns of a reversal of its stance if risks to the current account emerge. However, over the medium term, the exchange rate is driven by inflation differentials necessitating stable inflation

iii. Price stability alone is not sufficient for financial stability — as seen during the financial crisis. While undertaking price stability, financial stability can be met through macro-prudential regulation.

 iv. Challenge of undertaking inflation targeting in the backdrop of fiscal dominance. In this case, strong fiscal rules might be helpful. v. Operation of inflation targeting during a supply shock. Here, monetary policy does have a role to play, especially, if the supply shock is permanent as it affects the expectations.

There are certain prerequisites for the successful implementation of an inflation targeting policy:

 

 i. A clear mandate from the Parliament to the RBI on price stability and the setting of an appropriate target.

 ii. Unwavering commitment of the sovereign towards fiscal rules.

 iii. Choice of an appropriate index viz. WPI, CPI.

 iv. Time horizon over which the target would be achieved.

 

To sum up, in the light of recent experience, it is time to debate whether the multiple indicator approach to monetary policy has served us well. A rule-based framework towards inflation targeting can anchor inflationary expectations and immunize the central bank from short-term political/industry group pressures while serving the long-term interests of our country.

-Kapil Naresh Vyas