Context: Despite extensive research and econometric studies, there is no conclusive evidence that inflation targeting is the most effective monetary policy framework.
What is Inflation Targeting?
- Inflation Targeting is a monetary policy framework where the Central Bank of a country aims to maintain the rate of Inflation within a targeted (pre-defined) range.
- India adopted inflation targeting through the Monetary Policy Framework Agreement in 2015, signed between the Reserve Bank of India (RBI) and the Central Government.
- Objective: RBI's primary objective would be to maintain price stability while keeping in mind the objective of growth.
- Target: The RBI is required to maintain inflation of 4% (with a deviation of +/- 2%), i.e., between 2% to 6%.
Why the Need to Review Inflation Targeting?
1. Inflation-Growth Dichotomy:
- Inflation targeting relies on contractionary monetary policy (higher interest rates) to control inflation. However, such a policy would lead to an increase in rate of interest on loans, will raise borrowing costs, reduce private investment and consumption expenditure, thereby causing a decline in GDP growth rates.
2. Persisting Inflation:
- In Inflation targeting, controlling the money supply only alters demand-side inflation but does not address the inflation caused by 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.
3. Inefficient Monetary Policy Transmission:
- Despite a cumulative hike in repo rate of 250 bps (during May 2022 to October 2023), banks revised their marginal cost of funds-based lending rate (MCLR) only by 152 bps. Hence, the cost of credit still remains high for prospective borrowers, thereby discouraging capital investment.
Way Forward:
- Shift to flexible inflation targeting: Post-Global Financial crisis, the dominant view around the world is that flexible inflation targeting (FIT), rather than pure inflation targeting, is more efficient for monetary policy formulation. By FIT, during times of extraordinary shocks (pandemics or financial crises), Central banks could temporarily adjust their inflation target to allow for more economic flexibility.
- Address supply-chain constraints: Strengthening policy coordination with the government and undertaking structural reforms in the agriculture and developing efficient logistics and transport networks to address inflationary pressure due to supply-side shocks.