Do not tinker with ‘Flexible Inflation Targeting’

To shoot the bird’s eye, you need to see only the eye and nothing else, so goes the well-known Indian proverb. This was the simple underpinning of the Flexible Inflation Targeting (FIT), approach that has served the RBI’s monetary policy for the last four years. Inflation was the clean, clear target. The FIT worked with a band that specified a target for inflation at an average of 4 per cent but open to swinging up or down by two percentage points.

The cycle comes to an end this fiscal (March 31,2021), and the government has now to notify the average and the band within which the FIT will operate from hereon. The question now is: Is the current average and band good enough or given the experience of the last four years, does this need to change? RBI Governor Shaktikanta Das has said that a wider inflation target band will be meaningless as it will dilute its effectiveness in setting monetary policy.

The adoption of FIT through a legislative mandate on September 29, 2016 was a landmark decision and a milestone in the monetary and fiscal interface. India since than followed a contractual approach of inflation targeting under which the government decides and notifies the target, and gives the central bank operational independence to operate its policy instruments to deliver on the agreed target.

At a global level, (as per the IMF Annual Report on Exchange Rate Arrangement 2019) during 2019, 41 countries were reported to having inflation targeting, of which 36 countries worked with a floating exchange rate and five countries had a fixed exchange rate. The exchange rate is an important variable in monetary policy and in particular in inflation targeting because it impacts the liquidity management by the central bank.

Over the years, there has been an increase in the percentage share of inflation targeting economies, particularly emerging market economies. Most of these central banks operate with a band but a few central banks like European Central Bank (ECB) and the Federal Reserve of the US operate with a strict target of 2 per cent. Most of the central banks operate in a band where the upper end is 6 per cent and the lower band varies within a range of 1 per cent and 3 per cent. Almost all countries target CPI Inflation.

Since the inception of FIT in 2016, GDP growth starting 2016-17 and ending 2019-20 stood at 8.26, 7.04, 6.12 and 4.18 (all in Y-o-Y and in percentage terms ). In the same period, the average inflation rate was at 4.5, 3.6, 3.4 and 4.8 (in percentage terms). So in the first four years, the mandate has been met and to that extent it can be said that the monetary policy has been effective.

Covid hit

The onset of the SARs-Cov-2 pandemic, however, has put severe pressure on the monetary policy objective with unprecedented contraction in the growth rate of 23.9 per cent in Q1 and 7.5 per cent in Q2 of 2020-21, and an estimated contraction of 7.7 per cent for fiscal 2020-21.

The worrisome feature is that the headline inflation rate remained above the upper band of 6 per cent for eight consecutive months during the period April–November 2020 within a range of 6.20 per cent in June 2020 and 7.61 per cent in October 2020.

However, the December 2020 CPI inflation print, released on January 12, 2021, is at 4.59 per cent on Y-o-Y basis mainly on account of deceleration in food inflation by 3.87 per cent.

The Monetary Policy Committee (MPC) in its December 4, 2020 resolution had stated that the inflation rate will come down to 5.8 per cent in Q4 of 2020-21 and a 5.2 per cent to 4.6 per cent in H1:2021-22, with risks broadly balanced. Thus, the RBI is hopeful of returning to the target as soon as the supply side bottlenecks ease. So, the moot question is: should the government revise the FIT in its notification as the mandate to the MPC is revisited? The short answer is ‘No’.

Stick with FIT

FIT has worked reasonably well with the average of 4 per cent and a band of +/- 2 per cent. A reasonable band of 2 per cent on the lower side and 6 per cent on the upper side gives the RBI manoeuvrability for inflation management as India has many uncontrollable variables, most notably monsoons. Besides food inflation, fuel inflation is also dependent upon the volatility of crude oil prices.

Also, a 4 per cent headline inflation with an upper ceiling of 6 per cent keeps the core inflation (headline inflation minus food and fuel inflation) at an appropriate level as there is a co-movement of core inflation with the headline inflation and vice versa. Any increase in the band above 6 per cent will put pressure on the RBI in anchoring inflation expectations. Indian society has zero tolerance for a double-digit inflation rate and a rate higher than 6 per cent will have the potential threat of moving closer to double digits.

On the lower side of the band, any inflation rate lower than 2 per cent has the potential risk of the economy entering in a deflationary situation. Prior to the adoption of FIT, the RBI did not have the exposure in terms of responding to the CPI inflation, which gives a weightage of around 46 per cent to food inflation on which the RBI has no control as WPI was taken as inflation measurement.

Over the four-year period, the RBI’s CPI inflation forecasting (which is the intermediate target of the current monetary policy framework) has been reasonably successful.

RBI has also been effective in anchoring inflation expectation in a three-month and one-year ahead time frame.

FIT should not be considered as a statistical measure to balance the risk of inflation alone. In many ways, it is a barometer of measuring the quality of macroeconomic management particularly in a country where poverty predominates. As the late Savak Tarapore, former deputy governor of the RBI, used to say: “Inflation is the No 1 enemy of the poor”. Inflation management is critical and as is the current monetary policy objective of delivering “price stability keeping in mind growth”.

What is required is not the change in FIT but an effective fiscal and monetary interface with responsible and functional autonomy to the RBI. In these challenging times, the need is to tinker not with inflation targeting, but to allow the RBI autonomy with less fiscal dominance.

The writer is a former central banker and a faculty member at Bhavan’s SPJIMR. The views are personal. (Through The Billion Press)

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