The government is said to be considering a relaxation of the inflation target band from the current 2 per cent to 6 per cent range. Would Indian consumers be comfortable with a higher rate of inflation?
There is no clear answer to this question. In the past India has seen 7 to 10 per cent inflation in consumer prices, but these have been periods when price rise has led to unhappiness among the people.
While the government is said to be of the view that the RBI can’t be saddled with a rigid inflation target at a time when pushing growth is a priority, a change in the band, or more specifically, a higher rate at the upper end, is not necessarily a good idea for the coming five years, even from the Modi government’s point of view.
The RBI Governor also seems to be against this proposal, as he is of the view that inflation targeting loses its relevance with a wide band.
Inflation targeting framework
India adopted a flexible inflation targeting framework as a formal legal mandate of the RBI in March 2016. The RBI Act, 1934, amended through the Finance Act of 2016, established a modern monetary policy framework with a clear objective of achieving price stability while keeping in mind the objective of growth.
One of the sections of the amended law requires that the inflation target, set in terms of the year-on-year change in the headline Consumer Price Index, is to be determined by the central government in consultation with the Reserve Bank of India, once every five years.
In August 2016, the inflation target was set at 4 per cent with an upper tolerance level of 6 per cent and a lower tolerance level of 2 per cent. In March 2021, the government, in consultation with the RBI, is required to review the target.
Central banks with inflation targeting regimes define their target in terms of a) point target, b) point target with tolerance bands, and c) a range. Countries often start with a range, and after achieving a steady state of inflation, switch to a point target or a point target with a range.
India adopted a point target with a range. These have the advantage of being precise and giving a clear signal about the central bank’s objective. They are also symmetric, which conveys the central bank’s intention of avoiding deflation as effectively as it would avoid inflation. While a range provides some flexibility in the conduct of monetary policy, it also conveys that the central bank may have an imprecise control over the inflation target.
India’s inflation target band is one of the widest, barring a few countries like Argentina and Turkey. India’s inflation targeting framework has been broadly successful in reducing inflation. Despite the policy shocks and external headwinds, inflation has been reasonably range bound within the 4 per cent plus-minus 2 per cent band since the adoption of the inflation targeting regime in October 2016, except for the last few months.
Since the beginning of 2020, inflation has been mostly above the target range of 2-6 per cent. However, the rise in inflation in the recent months is largely on account of supply-side disruptions caused by the Covid-induced lockdown.
Why the proposal for wider band
The intent behind proposing a wider band is that the RBI should focus on reviving growth. However, the RBI has been prioritising growth, as seen from the monetary policy statements of the last few months. The policy repo rate has been cut by 115 basis points since the onset of the pandemic. The Monetary Policy Committee has also reiterated its commitment of following an accommodative stance as long as necessary to support growth.
A number of inflation targeting central banks have shifted their priorities to support growth, which has suffered a setback due to the disruption caused by the Covid-19 pandemic. The US Federal Reserve announced that it will allow inflation to run moderately above the 2 per cent target for some time to support the labour market and broader economy. These are seen to be temporary measures to support growth. Moreover, high inflation is not a problem in the US economy currently.
In India, the RBI Amendment Act requires the inflation target to be set for five years. This means that a wider target, if agreed to, would be applicable for a period of five years. At a time when growth seems to be recovering, and inflation may be inching up due to recovery in global demand, the proposal to widen the inflation target may need reconsideration.
Our study shows that while households’ inflation expectations have been relatively benign as compared to the previous inflation targeting regime, they are still higher than the actual inflation. Mandating a wider band may make the task of managing inflation expectations harder. Research shows that higher targets and wider target ranges are associated with high output and inflation volatility.
A review of the inflation target should be empirically sound and should take into account the global inflation outlook. While there is no consensus on a threshold level of inflation beyond which it turns adverse for growth prospects, the reasons for modifying the target must be documented and fully assessed.
Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.
Radhika Pandey is a consultant at NIPFP.
Views are personal.