India’s inflation targeting policy (Monetary policy)

Source – Live Mint

Syllabus- GS-3 Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.

Context- Inflation targeting and the decisions of  Monetary Policy Committee (MPC).

What causes inflation?

The primary cause of inflation is the mismatch between demand and supply. The mismatch can be in following context-

1. Excess money supply that raises aggregate demand
2. Supply deficiency (A shortfall in the production of a commodity fails to meet even the basic needs of the citizens and thus prices raise causing inflation).

What is the new monetary framework?

The agreement between the Reserve Bank of India (RBI) and the central government signed in February 2015. The agreement explicitly made inflation targeting the objective of the MPC while using the repo rate as the instrument for it.

• Rate steady– The Reserve Bank’s MPC was given the target of keeping inflation at 4% with a tolerance limit of 2%. This meant that inflation should be between 2% and 6%.
• Contrasting target – The target was in contrast with the multiple indicator approach that predated this framework where the central bank focused on both growth and price stability.

Thus, RBI was finally free to do its core job as guardian of the rupee’s value and granting currency the stability needed to serve as a credible unit for long-range forecasts.

What is inflation targeting? What are the views of critics?

Inflation targeting refers to keeping inflation rate within the permissible band so that business houses can plan their investment activities.

Procedure-

1. Review meeting– (every two months): Where MPC discuss the likely inflation and growth estimates over the coming months.
2. Targeting inflation: Based on this review, the MPC targets inflation using the policy rate, or the repo rate.

Critics’ view-

• Inflation targeting was ill-suited to an emerging economy like India.
• Flexible regime with a wide inflation band was far too rigid to foster growth.

Inflation in India has been subdued since the new monetary policy framework was brought in. Many view this as a sign of its success in India while others point at the tight policy and its adverse impact on India’s growth rate as a sign of problems with the framework, which has come at the cost of growth.

Way forward

Centre must not act in haste to abandon inflation targeting. Price stability is a goal too worthy to give up on. For the sake of fairness, if not the rupee, government should resist the temptation to use the “money illusion” of inflation for short-term ends.