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News: In 2021 and 2022, the present inflation rate in developed markets is much higher (8.5% in the US). Therefore, the central banks of developed markets (DM) like the US Fed, or the European Central Bank, or the Bank of England — all of them have chosen inflation targeting.
It has generated debate on the choice of the monetary policy between controlling inflation versus controlling the exchange rate, including in the context of India.
What are the two strategies of monetary policy for price control?
(A) Exchange Rate management: There is a connection between the price stability and the exchange rate management. The stabilization of the exchange rate can stabilise domestic prices. The exchange rate is largely determined by the government and not through market forces. It induced price stability.
How is monetary policy strategy with exchange rate management successful for price control?
It would foster price stability. However, the exchange rate management works well where products have goods arbitrage. It induces a low tradeables inflation while importing. For example, the RBI did exchange rate management between 1983-2021 period.
It had benefit of stabilising the tradeables inflation.
Why is Inflation Targeting being chosen as part of monetary policy nowadays?
(A) The exchange rate management have a lot of weaknesses
The monetary policy with exchange rate management does not work for a product where the product has a fair degree of import parity pricing.
The monetary policy with exchange rate management works well for a small country like Singapore. In India, which is a continental economy, many prices are not made through goods arbitrage, and low tradeables inflation is less valuable.
The monetary policy strategy based on exchange rate management is not optimal. It only stabilises the prices of tradeables. However, It ultimately harms growth and stability. For example, A great inflation began in India in 2006. It also resulted in a currency defence in 2013.
It works when global inflation is under control. For example, in this situation, if the RBI stabilises the USD/INR, it can lead to import of low tradeables inflation into India.
(B) Inflation Targeting can lead to several advantages
The inflation targeting works well for Import parity pricing. The prices of most commodities having merely feasible goods arbitrage are controlled by import parity pricing.
It also works for big sized economies like India. For example, India has chosen it in 2015 as India is a continental size economy.
Therefore, monetary policy shifted to inflation targeting in February 2015.
Ways Forward
For other developed markets, getting inflation down to a target of 2% consumer price index (CPI) inflation will take time.
The RBI can deliver a predictable 4% CPI inflation. It can lead to macroeconomic stability
Source: The post is based on an article “Focus on CPI inflation” published in the Business Standard on 17th April 2022.
