India’s Inflation Targeting Framework

Source-This post on India’s Inflation Targeting Framework has been created based on the article “Inflation targeting: Defending the status quo” published in “Business Standard” on 29 August 2024.

UPSC Syllabus–GS Paper-3– Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment.

Context– In September 2016, India set a 4% inflation target with a 2% to 6% range, reviewed every five years. The six-member Monetary Policy Committee (MPC), made up of three RBI members and three external experts, oversees this framework. The approach has successfully reduced inflation, minimized CPI volatility, and improved the effectiveness of monetary policy.

What are the arguments for modifying the approach to inflation targeting?

1) Broadening the mandate-

A) Critics suggest that the RBI’s mandate to ensure price stability and support economic growth needs to be broadened. Some propose giving the growth objective equal weight to price stability, similar to the US Federal Reserve’s dual mandate.

B) Others recommend including additional responsibilities, such as fostering the corporate bond market and advancing green finance.

2) Headline CPI -Headline inflation is problematic because volatile food prices can skew policy decisions. They recommend that the RBI ignore fluctuations in food price inflation.

3) Weight in the Inflation Basket– The current inflation basket gives food and beverages a 45.8% weight, unchanged since 2011-12, despite a near doubling of per capita incomes. As incomes rise, the share spent on food decreases: Bangladesh spends 45%, Vietnam 33%, Brazil 24%, and South Korea 14%.

4) Inflation Tolerance Band -The RBI’s ±2% tolerance band for inflation is broader than in many emerging markets. This wide band may weaken inflation control and increase expectation volatility.

What are the arguments against modifying the approach to inflation targeting?

1) Risks of Overloading the Central Bank -Assigning too many responsibilities to the central bank can distract from its primary role of maintaining price stability, complicate interest rate policy, destabilize inflation expectations, and reduce its accountability.

2) Impact of Food-Price Inflation on Core Inflation– Food-price inflation can affect core inflation as producers raise prices on other goods. The central bank shouldn’t react to every food price change, but consistently ignoring deviations from the target can have negative effects.

3) Suitability of India’s 4% Inflation Target– India’s 4% inflation target is higher than in other emerging countries but fits its fast-growing economy. Raising it to 6% or 8% could harm investment confidence, raise inflation expectations, and damage the RBI’s credibility.

4) Challenges of a Narrower Inflation Tolerance Band -Food prices are a major and volatile part of Indian inflation, so a narrower tolerance band isn’t practical. During global economic uncertainty, such a band could cause frequent interest rate changes, making investments unpredictable and slowing growth.

Read More- Inflation in India- Reasons and Solutions

What should be the way forward?

1) Optimizing Food Weight -Reducing the food weight in India’s inflation basket to 40%, and potentially to 30% over the next decade as incomes increase, would improve alignment with the inflation target and address concerns about food price changes.

2) Clear Inflation Target– India should maintain a clear anchor such as an inflation target, which has a proven track record of success. Avoiding radical changes, like broadening the RBI’s mandate or adopting a more discretionary approach, will help ensure stability and effectiveness.

Question for practice

Critically examine the need to modify the current approach to inflation targeting in India?