Inflation Targeting

Context:

Recently, the Indian Finance Minister stressed the importance of taming inflation but cautioned against using interest rate hikes as the sole solution.

More on News:

• Recently, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) decided to keep the main policy instrument (Repo rate) unchanged at 6.50%.
• It has hiked the inflation projection from 5.1 percent to 5.4 percent for FY2024 in the wake of the high food inflation.

About Inflation Targeting:

• Inflation targeting is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation. 
• Objective: Maintaining price stability, and price stability is achieved by controlling inflation.
• New Zealand pioneered inflation targeting in 1990, and it has since become a widely adopted approach in monetary policy worldwide.
• Significance: Inflation targets used in monetary policy
  • Inflation targets guide central banks in monetary policy.
  • They help determine interest rates.
  • Interest rates are raised when inflation or GDP growth exceeds desired levels.
  • Conversely, rates are lowered when these factors fall below desired levels.

MPC and its role Inflation Targeting: 

• In 2015, India’s central bank and government established a policy framework with a primary goal of ensuring price stability, while also considering growth objectives.The Flexible Inflation Target (FIT) framework was officially adopted in 2016, aligning India with other nations practicing flexible inflation targeting.
• To provide a legal basis for FIT, the Reserve Bank of India Act, 1934, was amended.
• Monetary Policy: It is a function of the central bank, which is chiefly aimed at regulating the size and cost of money in the economic system.
• Duration: The policy is a bi-monthly affair announced 6 times in a financial year.
• Monetary Policy Committee:
  • Monetary Policy Framework Agreement 2015: MPC was set up consequent to the agreement reached between Government and RBI to task RBI with the responsibility for price stability and inflation targeting. 
    • Under the amended RBI Act, 1934, the central government is empowered to constitute a six-member Monetary Policy Committee. 
  • The first such MPC was constituted in 2016. Under the Monetary Policy Framework Agreement, the RBI will be responsible for containing inflation targets at 4% (with a standard deviation of 2%) in the medium term (For more details see here). 
  • The Central Government determines the inflation target in terms of the Consumer Price Index, once in every five years in consultation with the RBI. 
  • Decision-making of MPC: 
    • The MPC takes decisions based on majority vote (by those who are present and voting). 
    • In case of a tie, the RBI governor will have the second or casting vote. 
    • The decision of the Committee would be binding on the RBI.

How CPI basket drives MPC inflation Target:

• The Consumer Price Index (CPI) basket is a key factor in setting the inflation target for the Monetary Policy Committee (MPC). 
  • It is released by the National Statistical Office (NSO).
• It measures price changes from the perspective of a retail buyer. 
• The CPI calculates the difference in the price of commodities and services such as food, medical care, education, electronics etc, which Indian consumers buy for use.
• Price movements of these items determine inflation. The government, with input from the central bank, sets an inflation target (4% with a +/- 2% range). 
• The MPC’s role is to use tools like interest rates to meet this target. 

Challenges related to inflation targeting:

• Accountability Issues: The CPI inflation target is set at 4% with an upper tolerance limit of 6%.
  • CPI  inflation has rose to 7.44% in July 2023.
  • If inflation remains above 6% for three consecutive quarters, the RBI must report reasons for failure and remedial actions to the government. Accountability has been a relatively new problem though.
• Monetary Dependence: India’s reliance on food items in its consumption basket necessitates government intervention to meet inflation targets.
  • RBI depends on government supply-side measures to curb food inflation, compromising monetary independence.
  • 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.
• Adverse impact on other sectors: The cases of IL&FS, PMC Bank, PNB and YES Bank suggest that poor management and maladministration in the financial sector can escape RBI scrutiny as they tend to focus more on inflation targeting.
  • RBI has kept the interest rates high to manage inflation. This has discouraged private investment thereby reducing employment and export potential.
• Disregards Multifaceted Role: In a developing country like India, focusing solely on inflation overlooks the central bank’s broader responsibilities, including fostering growth and financial stability.
• No Clear Link to Financial Stability: The 2008 Global Financial Crisis revealed that emphasizing price stability alone does not ensure financial stability. Overreliance on price stability can neglect regulatory functions, potentially leading to crises.
• Low GDP Growth: Tightening monetary policy to control inflation can lead to higher interest rates, reducing investment and consumption, and hindering GDP growth.
• Supply-Side Inflation: Inflation in India often stems from supply-side issues like rising oil prices or weather-related disruptions. In such cases, the central bank’s ability to influence inflation is limited, requiring government intervention.
  • The current surge in tomato and onion prices, for example, is primarily due to supply-side interruptions.

Suggestions to Improve Inflation Targeting:

• Alignment with Global Practices: The Reserve Bank of India (RBI) in its Currency and Finance (RCF) report has called for aligning the shut period with global practices. Shut down period is the period, in which MPC members maintain complete silence, i.e. no media coverage. 
  • Shorten Shut Period: Reduce the shut period from seven days to three days after the release of the Monetary Policy Committee (MPC) resolution for more effective market transmission.
• Shift to Core Inflation: Change the focus of inflation targeting from headline inflation to core inflation to better reflect the impact of monetary policy, especially on non-commodity components.
  • More than 50% basket of headline inflation comprises commodities that the RBI policy rate cannot affect. Especially fuel inflation.
• Regular CPI Measurement Updates: Improve the regular measurement of the Consumer Price Index (CPI), including frequent updates of the basket and its weights to align with changing consumption patterns.
• Expanded MPC Scope: Include discussions on liquidity issues (liquidity adjustment facility, changes in reverse repo, and open market operations) in MPC meetings to increase transparency and effectiveness.

Conclusion: 

• While controlling inflation is a crucial objective, it’s becoming increasingly clear that relying solely on interest rate hikes may not be the most effective approach, especially in the context of economic recovery. 
• Balancing inflation control with other growth-related priorities and addressing supply-side factors are vital components of a holistic strategy.

News Source: The Indian Express

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