The Inflation Targeting Framework in India, Credibility, Challenges, and Future Directions

The Inflation Targeting Framework in India, Credibility, Challenges, and Future Directions

Why in News?

The Reserve Bank of India (RBI) recently released a discussion paper reviewing the inflation targeting (IT) regime, which has been in place since 2016. With the second five-year review of the framework due in early 2025, the paper examines the efficacy of the current system, which targets 4% inflation with a tolerance band of ±2%. While the regime has largely succeeded in anchoring inflation expectations and ensuring macroeconomic stability, the discussion paper raises critical questions about its structure, including the optimal inflation target, the relevance of tolerance bands, and whether headline or core inflation should guide policy. This analysis delves into the achievements, challenges, and potential reforms of India’s monetary policy framework, emphasizing the importance of preserving credibility in a volatile global economic environment.

Introduction

Inflation targeting has been a cornerstone of India’s monetary policy since 2016, when the RBI formally adopted a flexible inflation targeting (FIT) framework. This shift marked a significant departure from the multiple-indicator approach previously used, aiming to provide clarity, transparency, and accountability in monetary policy decisions. The framework, governed by a six-member Monetary Policy Committee (MPC), has been instrumental in controlling inflation, which averaged 4.9% post-2016 compared to 6.8% in the preceding years. However, as the RBI prepares for its second review in 2025, the discussion paper invites a re-evaluation of the framework’s design amidst evolving domestic and global challenges, including supply shocks, climate change, and geopolitical tensions. This analysis explores the successes and limitations of inflation targeting in India and argues against drastic changes that could undermine the hard-earned credibility of the RBI.

Key Issues

1. Achievements of the Inflation Targeting Regime

• Inflation Control: The primary success of the FIT framework has been its ability to stabilize inflation. The average Consumer Price Index (CPI) inflation dropped to 4.9% (2016–2024) from 6.8% (pre-2016), reducing volatility and anchoring public expectations.

• Flexibility During Crises: The framework allowed the MPC to prioritize growth during emergencies, such as the COVID-19 pandemic, without abandoning its inflation mandate. This flexibility was crucial in supporting economic recovery.

• Transparency and Accountability: The publication of MPC minutes and reports to the government when inflation exceeded 6% enhanced transparency and held policymakers accountable.

• Global Recognition: India’s IT framework is aligned with global best practices, with 48 countries adopting similar regimes. No major economy has abandoned inflation targeting, underscoring its robustness.

2. Questions Raised in the RBI Discussion Paper

• Optimal Inflation Target: Is 4% the right target, or should it be adjusted to reflect structural changes in the economy?

• Tolerance Bands: Should the ±2% band be retained, narrowed, or eliminated?

• Headline vs. Core Inflation: Should policy focus on core inflation (excluding food and fuel) to avoid supply-side volatility, or continue targeting headline inflation?

• Framework Tweaks: How can the framework be adapted to address emerging challenges like climate change, digital currency, and financial stability?

3. Challenges in Implementing Inflation Targeting

• Supply-Side Shocks: Food and fuel inflation, driven by monsoons, global oil prices, and geopolitical events, often push headline inflation beyond the tolerance band. For example, inflation spiked to 7.8% in April 2022 due to the Ukraine war.

• Growth-Inflation Trade-off: Tight monetary policy to control inflation can stifle growth, especially in a developing economy like India where demand-side pressures are minimal.

• Transmission Issues: Despite policy rate changes, transmission to lending rates remains incomplete due to banking sector inefficiencies.

• Data Limitations: Volatile and revised CPI data complicate real-time policy decisions.

4. Global Comparisons and Lessons

• Advanced Economies: Countries like the UK, Canada, and Australia have successfully used IT for decades, often with targets around 2%. However, post-pandemic inflation surges have forced some to reconsider their frameworks.

• Emerging Economies: Brazil and South Africa use IT with wider bands to accommodate volatility. Uganda is the only country targeting core inflation, but this approach is criticized for ignoring food and energy price impacts on households.

• Tweaks, Not Overhauls: Most central banks make incremental changes (e.g., adjusting bands or incorporating financial stability) rather than abandoning IT altogether.

5. The Credibility Imperative

• Hard-Earned Trust: The RBI’s credibility has been built over years of consistent policy actions. Changing targets or bands could be perceived as easing constraints, risking de-anchoring inflation expectations.

• Investor Confidence: A stable monetary policy framework attracts foreign investment by reducing uncertainty. Eroding credibility could lead to capital flight and currency volatility.

• Policy Certainty: As the RBI notes, “monetary policy frameworks need both policy certainty and credibility.” Frequent changes undermine both.

Alternative Approaches

1. Asymmetric Inflation Targeting:

   • Allow higher tolerance for inflation above the target (e.g., up to 6%) while maintaining strict discipline for deflationary risks. This could accommodate supply shocks without compromising credibility.

2. Dual Mandate:

   • Explicitly include growth and employment in the policy mandate, similar to the US Federal Reserve. However, this may dilute focus on inflation control.

3. Core Inflation Targeting:

   • Shift to core inflation to avoid food and fuel volatility. But this ignores the impact of these prices on households, especially the poor.

4. Average Inflation Targeting:

   • Target average inflation over a cycle, allowing temporary overshoots. This approach, adopted by the Fed post-2020, provides flexibility but requires sophisticated communication.

5. Incorporating Financial Stability:

   • Expand the mandate to include asset prices and financial stability, as done by the European Central Bank. However, this complicates policy decisions.

Challenges and the Way Forward

• Structural Reforms: Addressing supply-side bottlenecks in agriculture and energy is essential to reduce inflation volatility.

• Improved Data Collection: Enhancing the accuracy and timeliness of CPI data will aid better policy formulation.

• Strengthening Transmission: Reforming the banking sector to ensure faster pass-through of policy rates is critical.

• Communication Strategy: The RBI must clearly communicate any changes to avoid market confusion.

The Way Forward:

• Retain the 4% Target: Changing the target could signal a willingness to tolerate higher inflation, undermining credibility.

• Keep Tolerance Bands: The ±2% band provides necessary flexibility without sacrificing discipline.

• Stick to Headline Inflation: Food and fuel prices matter for households and expectations. Ignoring them risks policy relevance.

• Incremental Reforms: Instead of overhauling the framework, focus on improving implementation, such as better forecasting and communication.

Conclusion

India’s inflation targeting framework has served the economy well, providing stability, transparency, and accountability. As the RBI reviews the system, it must prioritize preserving the credibility built over the past nine years. While minor tweaks may be necessary to address emerging challenges, drastic changes like raising the inflation target or switching to core inflation would be misguided. In a world of economic uncertainty, policy certainty and credibility are invaluable assets. The RBI should reinforce its commitment to price stability while continuing to support growth, ensuring that the framework remains fit for purpose in the years ahead.

5 MCQs Based on the Article

Q1. What is the current inflation target set by the RBI?
A) 2% with a ±1% band
B) 4% with a ±2% band
C) 5% with a ±2% band
D) 6% with a ±1% band
Answer: B) 4% with a ±2% band

Q2. How has average inflation in India changed after the adoption of inflation targeting?
A) Increased from 4.9% to 6.8%
B) Decreased from 6.8% to 4.9%
C) Remained stable at 5%
D) Volatility increased significantly
Answer: B) Decreased from 6.8% to 4.9%

Q3. Which country is mentioned as the only one targeting core inflation?
A) India
B) United States
C) Uganda
D) Brazil
Answer: C) Uganda

Q4. What is a key advantage of the inflation targeting framework highlighted in the article?
A) Elimination of all inflation
B) Flexibility during economic crises
C) Fixed exchange rates
D) Reduction in fiscal deficit
Answer: B) Flexibility during economic crises

Q5. Why does the article argue against shifting to core inflation targeting?
A) It is too complex to calculate
B) It ignores food and fuel prices that affect households
C) It is not used by any country
D) It focuses only on growth
Answer: B) It ignores food and fuel prices that affect households