The Reserve Bank is off target:

The Reserve Bank is off target:

Context:

One of the significant actions of the government of the day is to have moved monetary policy in India onto a “modern “plane.

Introduction:

• The RBI has been reconfigured as an ‘inflation-targeting’ central bank. As part of this arrangement, it has been set an inflation target of 4%.
• Consumer price inflation has now declined to 1.5% in June, though only 0,.5% below its lower bound, this inflation rate is far below the targeted 4%.

A flawed model:

• A model underlying inflation targeting is that inflation reflects output being greater than the economy’s potential. The task now is to bring output back to its potential level via an interest rate hike.
• The problem with the model is that the potential level of output is unobservable.

Key points:

• The Reserve Bank of India (RBI) is expected to reduce the key policy rate or the repo rate by 25 basis points (bps) to 6% in its monetary policy review meeting scheduled for August 2 while maintaining neutral stance on interest rates
• The Inflation for June was lower than the RBI’s target band of 2-6%.
• During the last policy review in June, the RBI revised its inflation projection downwards to 2-3.5% in the first half of the year and 3.5-4.5% in the second half-opening up the possibility of a rate reduction.
• The earlier projection for retail inflation in the first half of the fiscal was 4.5% and 5% in the second half.
• The Asian Development Bank’s latest estimate puts India’s average inflation in fiscal year 2018 at 4%, some 70 basis points lower than its estimate at the beginning of the year.
• Inflation based on the wholesale price index, or WPI, slipped to an 11-month low of 0.9% in June, with food inflation remaining negative and prices of manufactured items rising at a weak pace. Wholesale inflation has been on a downward trend since February
• The Wholesale Price Index also eased to 0.9 per cent from 2.17 %.
• Developing countries like India have an economic structure different from the developed ones of the West for which inflation targeting was first devised.
• Under inflation targeting, the response to rising agricultural prices would be to raise the rate of interest
• This may have some desirable impact on inflation but it can come only at the cost of output loss in the non-agricultural sector
• The output loss can only be rationalized as necessary by holding on to the assertion that inflation reflects actual output being greater than potential.

Role of agriculture:

• The role of agricultural prices in driving inflation in India is evident presently.
• The overall consumer price index is rising at 1.5% that for agricultural commodities is actually falling, reflecting the fall in the relative price of agricultural goods we have referred to.
• As agriculture price inflation continues to fall, driving down the overall inflation rate, the real rate of interest rises.