Inflation Targeting is a monetary policy framework wherein the Central Bank of a country focuses only on maintaining the rate of Inflation within a targeted range.
It was first adopted by New Zealand and subsequently, a large number of countries including India have been following inflation targeting as their core element of monetary policy.
In case of India, the inflation targeting was introduced through the Monetary Policy Framework Agreement signed between the RBI and Government in 2015.
As per terms of the agreement, RBI's primary objective would be to maintain price stability, while keeping in mind the objective of growth. The RBI is required to maintain a rate of inflation of 4% with a deviation of 2% i.e. inflation has to be maintained between 2% to 6%.
What Are Benefits of Inflation Targeting?
- Spur investment rate: Flexible inflation target (4+2) would help in achieving sustainable price levels in the markets and as a result may increase savings rate in the economy. This may spur investment rate in the economy leading eventually to higher GDP growth.
- Promotes export competitiveness: Stable price levels in an economy keeps a check on input prices of goods and services produced in the economy. This maintains the competitiveness of our goods in export markets thereby promoting export growth and reducing current account deficit.
- Increase Foreign investments: Improved transparency in inflation targeting reduces investor uncertainty allowing them to predict changes in interest rates, and anchors inflation expectations. This will lead to an increased foreign portfolio and direct investments in the longer run.
- Clear Policy Signal to Markets: The Inflation targeting explicitly states as to what would be the targeted rate of inflation in an economy. Such explicitly mandated targets bring in more clarity and predictability with respect to the rate of inflation and monetary policy formulation.
- Autonomy and Accountability of RBI: As per the Monetary policy framework agreement, the RBI has been given complete autonomy in maintaining the rate of inflation within the mandated targets. If the RBI fails to maintain the Inflation within the target, then it would be required to submit in writing the reasons for its failure. Such a provision enables the RBI to enjoy autonomy and at the same time, enables the Government to have enhanced accountability over the actions of the RBI.
- Empirical Evidence: Inflation targeting has been quite successful in some of the advanced economies such as the UK, New Zealand etc. These advanced economies have been able to maintain moderate rates of inflation for a much longer time leading to increased macro-economic stability.
What are Problems and Challenges with Inflation Targeting?
- Disregards the Multi-faceted role of RBI: In a developing country like India, it is not practical for the central bank to focus exclusively on inflation without taking into account the larger development context. The RBI needs to balance between growth, price stability and financial stability.
- Inflation-growth Dichotomy: Controlling inflation requires following contractionary monetary policy. However, such a policy would lead to an increase in rate of interest on loans leading to decrease in investment and consumption expenditure causing a decline in GDP growth rates. For example, during 2013-2015, the higher interest rates in the country on account of higher rate of inflation had led to decrease in the GDP growth rates.
- Poor Monetary Policy Transmission: The Inflation targeting is more suited to the developed economies since the monetary policy transmission in such economies is quite efficient. However, in case of India, the monetary policy transmission is quite inefficient and this can in turn reduce the effectiveness of Inflation Targeting. In response to the cumulative hike in repo rate of 250 basis points during May 2022 to October 2023, banks have revised their marginal cost of funds-based lending rate (MCLR) only by 152 basis points.
- Supply Side Constraints: Controlling the money supply only alters demand-side inflation and not inflation arising out of supply-side constraints. E.g. rise in prices of vegetables, pulses highlight supply side constraints which are out of the purview of the RBI and hence they continue to erode household savings.
- No Clear link between Price Stability and Financial Stability: Prior to 2008 Global Financial Crisis, advanced economies were able to maintain moderate rate of inflation for a long term mainly due to adoption of Inflation Targeting. It was believed that Inflation targeting was responsible for overall macroeconomic stability of the country. However, the 2008 Global Financial Crisis has clearly proved that price stability alone cannot lead to financial stability and the excessive focus of the Central banks on price stability may lead to neglect of other crucial functions such as regulation leading to the economic crisis.
- Empirical Evidence against Inflation Targeting in India: The RBI was able to maintain a stable rate of Inflation within the mandated range before pandemic. However, in spite of a stable rate of Inflation, the Indian economy faced challenges on multiple fronts. The GDP growth rate reduced to 25 quarter low of 5% for the first quarter of financial year 2019-20. The unemployment increased to a 45-year high of 6.1%. There was a contraction in the manufacturing activity as evident in declining IIP. The agriculture sector stared at agrarian distress. All these clearly highlight that the inflation targeting has failed to promote growth and development.
Conclusion
- Post-Global Financial crisis, the dominant view around the world is that flexible inflation targeting, rather than pure inflation targeting is more efficient for monetary policy formulation. During times of extraordinary shocks (e.g., pandemics or financial crises), central banks could temporarily adjust their inflation target to allow for more economic flexibility.
- Additionally, strengthening policy coordination with the government and undertaking structural reforms in the agriculture and transport sector will help India address inflationary pressure due to supply-side shocks.