Inflation Targeting(IT) is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation. 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. It is in-line with Urjit Patel Committee recommendations. An amendment to RBI Act by the Finance Bill, 2016, has made IT as the primary objective of RBI and it is also accountable in case of failure.
The Central Government has notified 4 percent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016, to March 31, 2021, with the upper tolerance limit of 6 percent and the lower tolerance limit of 2 percent.
The Reserve Bank of India, recently in the Report on Currency and Finance for FY21, has said the current inflation target of 4% with a +/-2% tolerance band is appropriate for the next five years.
Important observations made:
- Trend inflation had fallen from above 9% before flexible-inflation targeting (FIT) to a range of 3.8-4.3 % during FIT, indicating that 4% is the appropriate level of the inflation target.
- An inflation rate of 6% is the appropriate upper tolerance limit for the target.
- A lower bound above 2% can lead to actual inflation frequently dipping below the tolerance band while a lower bound below 2% will hamper growth, indicating that an inflation rate of 2 % is the appropriate lower tolerance bound.
Concerns over efficacy in inflation targeting:
- Logical vulnerabilities:
- However, what has remained hidden in public discourse is the economic model that underlies inflation targeting.
- This model revolves around the proposition that inflation reflects “overheating”, or economic activity at a level greater than the “natural” level of output, having been taken there by central banks that have kept interest rates too low, at a level lower than the “natural” rate of interest.
- From this follows the recommendation that the cure to inflation is to raise the rate of interest set by the central bank, the so-called policy rate, which in India is termed ‘repo’ rate.
- A feature of this theory of inflation is that its central construct, the natural level of output, is unobservable.
- This makes it next to impossible to verify the explanation, which is also self-referential.
- Despite this logical vulnerability, inflation targeting is a reality in that it is the Centre’s stated policy of inflation control.
- Mirage of success:
- Inflation targeting has been successful on the grounds that the inflation rate has remained within the band agreed to between the government and the RBI, and whether it has been achieved by “anchoring inflation expectations”.
- However, Inflation in India entered the prescribed band of 2% to 6% two years before inflation targeting was adopted in 2016-17.
- In fact, inflation had fallen steadily since 2011-12, halving by 2015-16.
- This by itself suggests that there is a mechanism driving inflation other than what is imagined in inflation targeting.
- The view is further strengthened by the finding that the decline in inflation over the five years concerned was led by the relative price of food.
- While falling food-price inflation per se does not rule out the possibility that expectations of inflation may have fallen in this period.
- But it would be difficult to explain why expectations would have fallen so sharply even in the absence of inflation targeting, considered essential for anchoring expectations.
- Finally, it is the flaring up of both inflation and inflation expectations after March 2020, when the COVID-19 lockdown was announced, that makes it difficult to believe the thesis of an “overheating” economy.
- On the other hand, we can explain the flaring up of inflation in terms of food prices, as supply chains were disrupted due to the lockdown.
- Conflicting patterns shown:
- Over the past five years, inflation in India has been controlled via inflation targeting and its benefits will be analyzed through five variables, namely growth, private investment, exports, non-performing assets (NPAs) of commercial banks, and employment.
- The economy’s trend rate of growth actually began to decline after 2010-11.
- So, inflation targeting could not have caused it, but it is of interest that sharply falling inflation could do nothing to revive growth, belying the proposition that low inflation is conducive to growth.
- For investment, there is reason to believe that higher interest rates, the toolkit for inflation targeting, may have been harmful.
- The swing in the real interest rate of over 5 percentage points in 2013-14 was powered further in 2016, when inflation targeting was adopted and could have contributed to a declining private investment rate.
- It is interesting that policy entrepreneurs assert that the benefits of low inflation may be considerable for private investment.
- Export and employment:
- Exports and employment performed fairly poor since inflation targeting became official.
- NPA’s (non-performing assets):
- It has long been recognized that a central bank focusing on inflation may lose control of financial stability.
NPAs have grown since 2016, and the cases of IL&FS, PMC Bank, PNB, and YES Bank suggest that poor management and malfeasance in the financial sector could escape scrutiny when the central bank hunkers down to inflation targeting.