Inflation Targeting In India

Source: The Hindu
GS III: Indian Economy

Why in the News?

India has completed 10 years of formal inflation targeting under the Reserve Bank of India (RBI).

News in Brief

• India follows a Flexible Inflation Targeting (FIT) framework, under which the RBI aims to maintain CPI inflation at 4%, with a tolerance band of ±2 percentage points.
• Inflation targeting primarily works through demand management and anchoring inflation expectations.
• The RBI raises the repo rate to make borrowing costlier, thereby reducing consumption and investment and moderating aggregate demand.
• However, recent analysis raises concerns that India’s Phillips Curve is relatively flat and household inflation expectations remain significantly above RBI projections, potentially limiting the effectiveness of monetary tightening.

Inflation Targeting: How does it work?

Inflation targeting primarily works through two channels- controlling aggregate demand and anchoring inflation expectations.

Demand Management Channel

• When inflation remains high, the RBI can increase the repo rate.
• This raises borrowing costs for households and businesses, which may moderate consumption and investment.
• As overall demand in the economy slows, upward pressure on prices is expected to ease.

Higher Repo Rate → Higher Borrowing Costs → Lower Consumption and Investment → Moderation in Aggregate Demand → Lower Inflationary Pressures

• However, this mechanism works best when inflation is driven largely by excess demand.

Inflation Expectations Channel

• Monetary policy also works by influencing how households and businesses expect prices to behave in the future.
• If people are confident that the central bank will keep inflation under control, they may be less likely to demand large wage increases or raise prices in anticipation of future inflation.
• In this way, a credible central bank can help moderate inflation expectations and reduce the risk of inflation becoming self-reinforcing.

Key Concern: A Flat Phillips Curve

• The Phillips Curve broadly captures the relationship between economic activity and inflation.
• Conventionally, stronger economic activity and employment are expected to increase demand and wage pressures, which can eventually push up prices.
• Accordingly, monetary tightening seeks to moderate demand and economic activity to reduce inflationary pressures.
• However, evidence discussed in the Indian context suggests that this relationship may be relatively weak.
• India’s New Keynesian Phillips Curve (NKPC) is considered to be relatively flat, implying that changes in output or aggregate demand may have only a limited impact on inflation.
• This raises an important policy concern: sharp increases in interest rates could slow investment, output and employment without producing an equally significant reduction in inflation.

Why may inflation targeting be less effective in India?

A significant share of inflation is Supply-Driven

• Inflation in India is often influenced by factors beyond domestic demand, particularly,
  • Food-price shocks
  • Monsoon and weather-related disruptions
  • Supply-chain bottlenecks
  • International crude oil prices
  • Global geopolitical developments
• Higher interest rates cannot increase the supply of vegetables, cereals or crude oil.
• Therefore, when inflation is mainly caused by supply disruptions, monetary tightening may have limited direct impact on prices.
• The central challenge is that monetary policy is better suited to addressing demand-side inflation, while a substantial part of India’s inflation is influenced by supply-side factors.

Weak Link Between Employment, Wages and Inflation

• The conventional Phillips Curve assumes that a tight labour market leads to higher wages, which can subsequently contribute to higher prices.
• However, India’s large informal workforce and relatively limited bargaining power of workers can weaken this relationship.
• Higher employment does not necessarily translate into proportionately higher wages, and wage increases may not always generate significant inflationary pressures.
• As a result, the conventional relationship between economic activity, wages and inflation may be weaker in India than assumed in standard monetary policy models.

Inflation Expectations Remain Sensitive to Everyday Prices

• The success of inflation targeting depends partly on the ability of the central bank to anchor inflation expectations.
• In India, however, household perceptions of inflation are often strongly shaped by changes in everyday expenses such as,
  • Food prices
  • Fuel costs
  • Housing and other essential expenses
  • Previous experiences of inflaiton
• Consequently, households may continue to expect high inflation even when the central bank projects a decline.
• This can limit the effectiveness of monetary policy communication and make inflation expectations more difficult to anchor.

Arguments in favour of inflation targeting

Despite these limitations, inflation targeting has strengthened India’s overall monetary policy framework.

Greater Focus on Price Stability

• The framework provides the RBI with a clearly defined inflation objective and helps place price stability at the centre of monetary policy.
• This has contributed to greater policy discipline and a more systematic approach to managing inflation.

Greater Transparency and Accountability

• Inflation targeting has made monetary policy more transparent by clearly communicating the inflation objective and the reasoning behind policy decisions.
• It has also strengthened:
  • Predictability of monetary policy
  • Institutional accountability
  • Communication by the Monetary Policy Committee (MPC)

A Clear Nominal Anchor for the Economy

• A defined inflation target acts as a nominal anchor, providing households, businesses and financial markets with a clearer indication of the RBI’s long-term policy objective.
• This can reduce uncertainty and improve confidence in monetary policy.

Flexibility Within the Framework

• India follows a flexible inflation-targeting framework rather than a rigid one.
• The tolerance range of 2% to 6% around the 4% target provides some room to accommodate temporary shocks while allowing the RBI to consider growth and broader macroeconomic conditions.

Challenges of Inflation Targeting In India

When is the Inflation Target considered to have failed?

• Under India’s flexible inflation-targeting framework, the RBI is considered to have failed to meet the inflation target if the average inflation rate remains above 6% or below 2% for three consecutive quarters.
• In such a situation, the RBI is required to submit a report to the Central Government explaining:
  • The reasons for failing to meet the inflation target
  • The remedial measures proposed to address the situation
  • The estimated time required to bring inflation back within the target range.

Way Forward and Conclusion

India should retain flexible inflation targeting while complementing monetary policy with fiscal and supply-side measures.

Strengthening supply chains, improving inflation forecasting and ensuring better policy coordination can help manage inflation without adversely affecting growth and employment.

UPSC Prelims and Mains Practice Question

With reference to the Flexible Inflation Targeting Framework in India, consider the following statements:

1. The Reserve Bank of India targets Consumer Price Index (CPI) inflation at 4%, with a tolerance band of ±2 percentage points.
2. The Monetary Policy Committee is responsible for determining the policy repo rate.
3. Inflation targeting can directly address inflation caused by a temporary shortage of agricultural commodities.

Which of the statements given above are correct?

(a) 1 and 2 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3

Answer: (a)

Mains Practice Question

Q, Inflation targeting is an important nominal anchor for macroeconomic stability, but its effectiveness in India is constrained by the structural and supply-side nature of inflation. Discuss. (150 words)

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