A recent development in the Indian economy has stirred the news segments across the country. The Reserve Bank of India’s Monetary Policy Committee (MPC) is currently reevaluating the effects of their past actions due to a decision to halt the increases in interest rates that they have consistently implemented since May 2021. The main aim behind these increases was to control inflation, which, at the time, was significantly higher than the target level of 4% set by the RBI.
Understanding Inflation Targeting
Inflation targeting has been a staple strategy in India since being integrated into the monetary policy framework of the RBI in 2016. This policy allows the RBI to set a target for the inflation rate and use different strategies and tools within monetary policy to achieve it. Their primary goal is to hit the 4% inflation target. To account for market fluctuations, the RBI has established a comfort range of +/- 2%, keeping inflation between 2% and 6%. As of the most recent data (January and February 2023), the inflation rates are 6.5% and 6.4%, respectively.
Rationale Behind Pausing Interest Rate Hikes
The RBI has acknowledged some limitations in its strategy of utilising interest rate hikes as a tool to control inflation. According to the institution, under the current macroeconomic conditions, only using monetary measures might not be enough to control inflation. They argue that fiscal policy, which encompasses the government’s taxation and spending, could play a more pivotal role in lowering the current levels of inflation.
The Advantages and Disadvantages of RBI’s Inflation Targeting Approach
Adopting the inflation targeting strategy also enhances the transparency and accountability of the central bank. It allows both investors and the public to predict changes in interest rates, ultimately reducing inflation expectations. However, the inflation targeting approach also comes with its limitations.
A significant obstacle is that it has a limited effect on supply-side factors such as crop failures, natural disasters, and global commodity price shocks due to geopolitical disturbances. Inflation targeting mainly controls demand-side factors like money supply and interest rates, limiting its effectiveness against supply-side shocks.
Additionally, the policy may fail to address structural problems that contribute to inflation, including inefficient distribution systems, inadequate infrastructure, and bureaucratic hurdles. There’s also a risk of conflict with other macroeconomic objectives such as economic growth, employment, and income distribution.
UPSC Civil Services Examination: A Retrospective
An examination of previous year questions (PYQ) from the UPSC Civil Services Examination provides further insight into India’s inflation management strategies. The examination in 2010 queried the availability and weighting of the Wholesale Price Index (WPI) in relation to the Consumer Price Index for Industrial Workers (CPI(IW)). Ten years later, in 2020, the examination focused on the weightage of food in the Consumer Price Index (CPI) vs the Wholesale Price Index (WPI), and whether the RBI had adopted the WPI as its key measure of inflation for determining key policy rates.
