How Effective was India’s Inflation Targeting as a Framework of Monetary Policy?

Monetary policy is a macro-economic policy laid down by the Central Bank of the country (Reserve Bank of India, in India) to manage interest rates, money supply, and availability of credit in the country. The primary objective of monetary policy is price stability. The amount of money supply is a determinant of inflation, and inflation determines price stability. Therefore, RBI can resort to either contractionary or expansionary monetary policy to maintain price stability. Expansionary monetary policy refers to an increase in the money supply, which keeps the interest rates low, thus enabling liquidity in the economy. Contractionary monetary policy refers to a decrease in money supply, which results from higher interest rates. 

The Reserve Bank of India (RBI) Act,1934 was amended in 2016 and is provided for the legal basis for implementing a flexible inflation targeting framework. This amended act provides the Government of India to decide the inflation rate by consulting with the RBI once every five years. Under this flexible inflation target framework, the inflation target was set at 4%+/-2% from 2016 to 2021. Thus, the upper tolerance limit was set at 6%, and the lower tolerance limit was 2%. This Act also laid the provisions to constitute Monetary Policy Committee (MPC), consisting of 6 members – 3 ex-officio members from RBI and 3 members appointed by the government. The members will hold office for 4 years and cannot be reappointed. MPC has to meet at least 4 times annually. Inflation targeting originated in Germany and Switzerland in the 70s after the Bretton Woods International Monetary System collapse. It stimulates the market demand by making people expect higher prices in the future and demand more now rather than in the future, which may eventually lead to economic growth.

As the five-year tenure of inflation targeting ended in March 2021, it is important to know whether it has proved to be effective or not for India. The average inflation rate, which was 5.69% in the pre-inflation targeting period, declined to 3.47% during the inflation targeting regime when measured through the GDP Deflator. Consumer Price Index (CPI) inflation which was 8.26% in 2011-2015, also declined to 4.99% during the 2016-2019 period. When compared with other countries in Asia, which also adopted IT regimes, India was one of the highest achievers in this regard. India was also able to reduce average inflation volatility during the said period. Inflation targeting policy also improved monetary policy transparency in India; this is one reason why IT is one of the popular policy instruments among the emerging countries. This transparency helped in reducing the consumer’s inflation expectations and made the policy forward-looking. In a nutshell, the IT regime has proved successful in India, and RBI has maintained its credibility through it. However, it is criticized that inflation targeting focuses just on price stability, ignoring growth imperatives. From 2016-2020, there were several times when the interest rates were kept too high for business, hurting economic growth. Some criticize that RBI should focus on the core retail inflation rate, eliminating the volatile fuel and food prices rather than headline retail inflation because it keeps on fluctuating in the short term due to changes in the economy, and it won’t be the best indicator then. Some others argue that RBI should look at wholesale inflation and not retail inflation. The changes in the interest rate by RBI would change credit available to businesses, which are affected by wholesale inflation and not retail inflation.

Even with this list of complaints and criticisms, RBI decided to keep the inflation target unchanged for the next five years starting from 1st April 2021 at 4% with a 2 percentage points band on both sides. But it was suggested that some aspects of the monetary policy framework need to be reviewed to correct the limitations of keeping inflation in check because of the pandemic crisis. The selection process of MPC members also needs revision. The pressure on yields has not worsened because of the rising prices, but the central bank needs to take measures to keep borrowing costs low to boost economic growth after the pandemic. It was observed that though the retail inflation was within the band, it was definitely higher at 5% from 4.1% prevalent before 8 months, that is, before the pandemic. Moody’s Analytics also claimed that CPI inflation did cross the 6% rate several times in 2020, owing to rising food prices and volatile oil prices. Increased inflation is a regressive tax and hits the poor the most. The government has relaxed a lot of regulations during the crisis period to boost economic growth. Still, in the post-pandemic period, macroeconomic stability will come to focus again, and there will be a need to increase economic growth. With this, the price volatility may increase, leading to spiking inflation again, and hence the Government must resort to the same inflation target rate. Flexible inflation targeting (FIT) has proved to be effective in India, but this policy has some criticisms. For an economy, it is important to look at price stability, but it is equally important to look at increasing output growth, which seems to be ignored in the FIT regime. Hence, the Government and RBI should make some changes in the monetary policy framework by adopting an integrated approach to overcome the policy’s limitations.