RBI’s inflation targeting: Why flexibility should not undermine focus

In May 2016, the Reserve Bank of India Act, 1934, was amended to formally establish a flexible inflation targeting (FIT) framework in India. Under Section 45ZA of the Act, the Union government, in consultation with the Reserve Bank of India (RBI), is required to set an inflation target—based on the Consumer Price Index (CPI)—every five years.

The first inflation target, along with a tolerance band, was notified on August 5, 2016, for the period 2016-21. During the first review in March 2021, the same target was retained for another five years, up to March 2026.

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A second review is now due before the end of March 2026. For this, the RBI has presented a discussion paper and sought public opinion on four different aspects of the subject:

1. Will headline inflation or core inflation best guide the conduct of monetary policy, given evolving relative dynamics of food and core inflation and the continuing high weight of food in the CPI basket?

2. Will the 4 per cent inflation target continue to remain optimal for balancing growth with stability in a fast-growing, large emerging economy like India?

3. Should the tolerance band around the target be revised in any way? If yes, should it be narrowed, widened, or fully done away with?

4. Should the target inflation level be removed, and only a range be maintained within the overall ambit of maintaining flexibility without undermining credibility?

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Headline and core inflation

Headline inflation and core inflation are both measures of inflation, but they differ in what they include. Headline inflation measures the total inflation within an economy, including items like food and energy, which can be volatile. Core inflation, on the other hand, excludes volatile components like food and energy, focusing on the underlying, more persistent inflation trend.

A 2020 RBI paper by Deputy Governor Michael Debabrata Patra and Harendra Kumar Behera stated that a 4 per cent inflation target aligns with India's average trend inflation since 2014.

Let us revisit the preamble of the RBI Act, which gives a clear mandate to the Reserve Bank to “maintain price stability, while keeping in mind the objective of growth”.

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Price stability means holding the value of purchasing power of the currency issued by the RBI. Hence, the RBI's job is to maintain the value of the currency issued by it, and this is possible only when the headline inflation is managed.

If core inflation alone is addressed, it means that the central bank does not address the value of its currency in toto. This will be a deviation from the preamble mentioned in the RBI Act.

Headline inflation is required to understand the cost of living for citizens and hence is important. For policy decisions and maintaining inflation within a band, it may be easier for the RBI when core inflation is addressed, but it does not help the citizens.

Four per cent target

A 2020 paper by former RBI Deputy Governor Michael Debabrata Patra and economist Harendra Kumar Behera stated that a 4 per cent inflation target aligns with India's average trend inflation since 2014.

It is also believed that setting the target too high could make monetary policy too expansionary, leading to more inflationary shocks, while 4 per cent provides a balanced approach for growth.

Some research indicates that inflation exceeding certain thresholds, around 4 per cent, can negatively affect economic growth, while other studies have identified higher thresholds but generally agree that excessive inflation is detrimental. Very low inflation rates, known as creeping inflation (under 3 per cent), are generally considered safe and essential for economic growth.

Abandoning a particular target level and keeping a range will make the central bank to focus only on the range.

Asset growth

People want their assets to grow, even if it is on account of general inflation. It gives some satisfaction to compare the purchase price of their assets with the present market price. They do not mentally perceive the effect of inflation on the price of their holdings.

If the price is at the same level, even with deflation, people may feel there is no sufficient return on investment and hence stop savings and investment. Even wage earners or pensioners are happy when their dearness allowance is increased on account of inflation and they do not ponder over the fact that the compensation of dearness allowance neutralisation is often not 100 per cent.

Hence, keeping the target at 4 per cent or 3 per cent should be ideal.

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Tolerance level

There is always a gap between policy-level prescription from RBI and its actual effect on the economy. For example, if the repo rate is changed, it takes time to get the market interest rates aligned to it.

There are inflows and outflows of foreign funds on which the central bank may not have much control and all these disturb the money in circulation and hence the inflation rate.

Hence it may not be practical to have a definite inflation rate and there has to be some flexibility for the RBI to react to any current situation. Maintaining the current dispensation of plus or minus 2 per cent can therefore be continued.

Keeping range alone

Abandoning a particular target level and keeping a range will make the central bank focus only on the range. Having a fixed rate as a target can make the central bank more vigorous in its purpose of maintaining price stability. Keeping the range itself as a target will dilute its responsibility and make it complacent.

Compare this with the rule that all the staff members must arrive at the office punctually. Allowing some employees to come late on some days is different from making a rule that anyone can come within a one-hour time band.

Deviation should not be made a rule. Even now, though there is a tolerance band, the target is sacrosanct. This will keep the rigour of monetary policy to maintain price stability.

On the whole, the RBI is doing a good job of balancing inflation and growth, and it should not lose its grip.