The 4% inflation target was adopted by the RBI as per the recommendations of Urjit Patel committee in 2014. The actual target range suggested by the committee was 4+/-2 %.
The recently constituted Monetary Policy Committee (MPC) has a mandate to ensure that the headline CPI inflation remains in the aforementioned range.
The set rate target can be considered a high inflation rate, affecting the less informed people negatively as:
- Nearly 85% of Indian workforce works in the informal sector, without inflation-linked wages. Higher inflation leads to a decrease in their purchasing power and increases poverty.
2. Higher rates of inflation affect the household savings, since the real savings deposit rates are rarely more than 1-1.5%, leading to poor returns on investment.
3. Senior citizens and older persons in India lack a social security net (annuity plans etc.) at present. Inflation adversely affects their financial situation, especially if their savings are in the form of cash.
4. The above effects contribute to increasing inequality, since the well-informed, financially literate people have inflation-linked wages or can invest in instruments that give higher rate of returns on investment.
5. In an economy clocking a GDP growth of 6.5-7%, keeping an inflation target of 4% leaves a very narrow window to set nominal interest rates. Macroeconomic fluctuations and resulting decisions will either harm the producer enterprises, or the consumers.
However, there are prudent reasons why the 4% inflation target was decided upon:
- Inflation dynamics in India are highly dependent upon food prices. Food inflation depends on structural factors such as oil prices, rural connectivity etc. Thus, setting a 4% rate is realistic considering the present situation.
2. Inflation acts as an impetus to producers, since they produce more in anticipation that their product prices will increase in the future. This mechanism results in GDP growth. In this context, inflation is a “necessary evil”.
3. The rate of 4% with an outer tolerance of limit of 6% also keeps in focus the future possibility of a hike in oil prices pursuant to decisions by OPEC and other oil producer countries.
4. RBI maintains that a real interest rate of 1.5-2% is ideal, and the 4% inflation target along with policy rates of 6.5-7% fits into these calculations.
5. Keeping a lower interest rate (say 2%) gives RBI less room to manoeuvre in case of macroeconomic volatility (as seen during the double digit inflation years in 2012-13), and is very near to the zero lower bound (0% rate, below which would be negative rate territory).
High inflation is detrimental to the economy. However, central banks consider a multitude of variables before arriving at realistic and plausible targets to achieve the objectives of monetary policy – balanced economic growth and near-full employment. The 4% target set by RBI is one such target, and it can be revised any time in the future as per the demands of the economy.
