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Insights into Editorial: Prudence prevails: on speculation about inflation

 

Context:

The Finance Ministry has put to rest all speculation about the inflation targeting framework that will guide the interest rate decisions of the RBI’s Monetary Policy Committee over the five-year period starting on April 1.

In a terse notification, the Department of Economic Affairs announced that the inflation target for the quinquennium ending on March 31, 2026, will be 4%, with an upper tolerance level of 6% and a lower tolerance level of 2%.

Economic Affairs Secretary said that the framework’s parameters would remain unchanged from what had prevailed in the five years that ended on March 31.

 

About Monetary Policy committee:

It is a statutory and institutionalized framework under the Reserve Bank of India Act, 1934, for maintaining price stability, while keeping in mind the objective of growth.

The 6-member Monetary Policy Committee (MPC) constituted by the Central Government as per the Section 45ZB of the amended RBI Act, 1934. The first meeting of the Monetary Policy Committee (MPC) was held on in Mumbai on October 3, 2016.

The Governor of RBI is ex-officio Chairman of the committee. The MPC determines the policy interest rate (repo rate) required to achieve the inflation target (4%).

An RBI-appointed committee led by the then deputy governor Urjit Patel in 2014 recommended the establishment of the Monetary Policy Committee.

 

Monetary Policy objectives:

  1. It is the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.
  2. In India, monetary policy of the Reserve Bank of India is aimed at managing the quantity of money in order to meet the requirements of different sectors of the economy and to increase the pace of economic growth.
  3. The RBI implements the monetary policy through open market operations, bank rate policy, reserve system, credit control policy, moral persuasion and through many other instruments.

 

What Is Inflation Targeting?

  1. Inflation targeting is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation.
  2. The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation.
  3. As a strategy, inflation targeting views the primary goal of the central bank as maintaining price stability.
  4. All of the tools of monetary policy that a central bank has, including open market operations and discount lending, can be employed in a general strategy of inflation targeting.
  5. Inflation targeting can be contrasted to strategies of central banks aimed at other measures of economic performance as their primary goals, such as targeting currency exchange rates, the unemployment rate, or the rate of nominal Gross Domestic Product (GDP) growth.

 

Tools for inflation targeting:

Liquidity Adjustment Facility- With this RBI controls the money supply in the economy. These interest rates and inflation rates tend to move in opposite directions.

Open Market Operations– RBI buys or sells short-term securities in the open market, thus impacting money available with the public.

Variable Reserve Requirement- Cash Reserve Ratio (CLR) and the Statutory Liquidity Ratio (SLR) are increased or decreased in accordance with inflation or deflation respectively.

Bank rate- It is the rate at which RBI lends money to commercial banks without any security. When bank rate is increased interest rate also increases leading to inflation.

Moral Suasion- If there is a need RBI can urge the banks to exercise credit control at times to maintain the balance of funds in the market.

If the central banks could ensure price stability, households and companies can plan ahead, negotiating wages on the basis of expecting low and stable inflation.

 

Maintaining Inflation Targets by RBI:

  1. The RBI’s officials have in recent months maintained an unwavering focus on emphasising the need to retain the flexible inflation targeting framework.
  2. In recent, working paper titled ‘Measuring Trend Inflation in India’, the Deputy Governor overseeing monetary policy underscored the importance of ensuring the appropriateness of the inflation target.
  3. Observing that there had been a steady decline in trend inflation to a 4.1%-4.3% band since 2014, they said a target far lower than the trend ran the risk of imparting a ‘deflationary bias’ that would dampen economic momentum, while a goal much above the trend could engender expansionary monetary conditions that would likely lead to inflation shocks.
  4. The RBI’s researchers authoring its Report on Currency and Finance themed ‘Reviewing the Monetary Policy Framework’ made clear that the framework had served the economy well, attested by a decline in inflation volatility and more credible anchoring of inflation expectations.
  5. That the government’s economic officials have heeded these calls will certainly reassure investors and savers that inflation remains a central concern for all policymakers.

 

Conclusion:

The latest Consumer Price Index data show retail inflation accelerated by almost 100 basis points to a three-month high of 5.03% in February, with food and fuel costs continuing to remain volatile.

Also, with the prices of multiple raw materials on an upward trajectory, an IHS Markit India Business Outlook survey showed companies were planning to raise selling prices over the coming 12 months to cope with rising costs.

The government’s announcement is a welcome step in reiterating that inflation targeting remains the centrepiece of the monetary policy framework and signals that the fiscal and monetary authorities are in lockstep in ensuring the primacy of price stability as the bedrock for all macro-economic development.