Money & Banking

Flexible inflation targeting: “If it ain’t broke, don’t fix it”, say RBI officials

Our Bureau Mumbai | Updated on December 28, 2020

Maintaining the inflation target at 4 per cent is appropriate for India in the backdrop of the steady decline in trend inflation to 4.1- 4.3 per cent since 2014, according to Reserve Bank of India (RBI) working paper.

The aforementioned observation assumes significance given that the flexible inflation targeting/ FIT (formally instituted in June 2016), which commits the RBI to a consumer price inflation (CPI) target of 4 per cent with an upper and lower tolerance band of +/- 2 per cent, has to be reviewed by end-March 2021.

The paper’s authors — Harendra Kumar Behera, Director, and Michael Debabrata Patra, Deputy Governor, RBI — underscored that: “The credibility bonus accruing to monetary policy warrants smaller policy actions to achieve the target (FIT). This points to maintaining the inflation target at 4 per cent into the medium-term. If it ain’t broke, don’t fix it.”

Real time trend inflation

The authors observed that trend inflation provides the metric to gauge the appropriate level of the target going forward.

According to the paper, central to the design and conduct of monetary policy is the concept of trend or steady state inflation. It is the level to which actual inflation outcomes are expected to converge after short run fluctuations from a variety of sources, including shocks, die out.

As per the paper, the real time estimate of trend inflation was around 5 per cent until the end of 2013, but it declined steadily thereafter to 4.1 per cent in Q1 of 2019, before inching up thereafter during the COVID-19 pandemic.

“Smoothed probability estimates weighted average trend inflation – our preferred trend inflation estimates – declined from above 5 per cent until Q2 of 2008 to around 5 per cent by 2009.

“It eased steadily thereafter and remained at 4.3 per cent in Q1 of 2020,” authors Behera and Patra said.

The authors said it is worthwhile to note that trend inflation still remains above the target under FIT, although it is on a declining trajectory. This indicates that inflation expectations are not yet fully anchored to the target but convergence is under way, they added.

Published on December 28, 2020

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