The Reserve Bank of India (RBI) recently stated in its Currency and Finance report for 2020-21 that retaining the current inflation target band of 4% +/-2% would be suitable for the next 5 years.
Defining Inflation Targeting
Inflation targeting is a vital policy of central banks, aimed at manipulating monetary policy to realize an established annual inflation rate. The philosophy behind this revolves around the idea that long-term economic progress is achieved best by maintaining price stability, which in turn is managed by controlling inflation.
A strict inflation target is set when the central bank focuses solely on maintaining inflation as close as possible to the given target. On the other hand, a flexible inflation target is adopted when the central bank also considers other elements such as stability of interest rates, exchange rates, output, and employment.
The Genesis of India’s Flexible Inflation Target Framework
The central bank, in agreement with the government, formulated a policy framework in 2015. This was done with the underlying objective of ensuring price stability while also considering growth. In 2016, the Flexible Inflation Target (FIT) was adopted, bringing India in line with other nations with similar targets.
Consequently, the Reserve Bank of India Act, 1934 was amended to provide a legal basis for the FTI framework. The revised Act mandates the government to set the inflation target every five years, in consultation with the RBI.
Characteristics of the FIT Framework
India’s mandate under the flexible inflation targeting approach is 4 (+/-2) percent, with headline consumer price inflation as a key indicator. This targeting system is known to bring about stability, predictability, and transparency in deciding monetary policy. It also helps reduce uncertainties and the negative impact of rising prices on savings and investments.
The FIT framework also makes the RBI more accountable by requiring it to explain to the government any failure to meet the established inflation targets. However, such targets may limit the RBI’s ability to adopt either a tight or accommodative monetary policy stance.
RBI’s Stand based on the RCF Report
According to the RCF report, trend inflation has fallen from over 9% before FIT to a range of 3.8-4.3% during FIT. This suggests that 4% is the fitting level for the inflation target of the country. The report also mentions that an inflation rate of 6% is the acceptable upper tolerance limit for the inflation target, while a lower bound below 2% could hamper growth.
During the FIT period, monetary transmission across the money market has been full and reasonably swift but less than complete in bond markets. Although there has been an improvement in transmission to lending and deposit rates of banks, implementing external benchmarks across all categories of loans and deposits could enhance transmission.
Overview of Monetary Policy
Monetary policy is a macroeconomic strategy determined by the central bank. It involves managing money supply and interest rates to achieve macroeconomic objectives like inflation, consumption, growth, and liquidity. In India, the aim of the RBI’s monetary policy is to manage the quantity of money to meet the needs of different sectors of the economy and accelerate economic growth.
The RBI implements the monetary policy through open market operations, bank rate policy, reserve system, credit control policy, moral persuasion, among other instruments. Central banks also typically alternate between accommodative and tight monetary policies in varying degrees to encourage growth while keeping inflation under control.
The Role of Monetary Policy Committee
The Monetary Policy Committee is a statutory and institutionalized framework under the Reserve Bank of India Act, 1934, for maintaining price stability while keeping the objective of growth in mind. The committee determines the policy interest rate (repo rate) required to achieve the inflation target of 4%. It was recommended by an RBI-appointed committee led by then deputy governor Urjit Patel in 2014.
Looking to the Future
For conducting monetary policy in an open economy setting, foreign exchange reserves and associated liquidity management are crucial. Thus, there is a need to augment the RBI’s sterilisation capacity to deal with surges in capital flows. The primary focus of FIT on price stability bodes well for further liberalization of the capital account and eventual internationalization of the Indian rupee.