Inflation targeting has been a success

In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a Constitutional basis for the implementation of the flexible inflation targeting (FIT) framework.

The Act allows the Centre to set the inflation target in consultation with the RBI once every five years. On that basis, India’s inflation target was set at 4 per cent with a 2 per cent extension in the upper bound and 2 per cent in the lower bound.

With its five-year tenure coming to an end, and the government of mind to continue with the regime, how effective has been the targeting in keeping inflation in check and stabilising its volatility?

The average inflation rate measured through the GDP deflator has declined significantly in the inflation targeting regime.

The average inflation, which was 5.69 per cent five years in the pre-inflation targeting period, has declined to 3.47 per cent in the last five years.

If we compare the same with countries following inflation targeting in Asia, there is clear evidence that India is one of the highest achievers of reducing inflation. Also countries in Asia that did not adopt inflation targeting had a patchy record in reducing prices.

Similar evidence is observed when we consider CPI-based inflation. Consumer Price Index inflation declined from 8.26 per cent during the 2011-2015 period to 4.99 per cent in 2016-2019, a 3.27 percentage point fall.

This is highest among both inflation-targeting countries as well as those that did not adopt it. While the RBI/MPC can take due credit for reining in the inflation, softening of international commodity prices and domestic food prices also contributed to it besides moderation in minimum support prices.

India has also achieved a substantial fall in average inflation volatility during the said period.

The average inflation volatility which was 7.93 per cent five years before inflation targeting has declined to 0.89 per cent during the inflation targeting regime. The fall in volatility is highest compared to Indonesia, Thailand, the Philippines, and Korea. A similar trend was seen in comparison with other non-inflation targeting countries.

Maintaining a stable inflation rate provides certainty to inflation and investment decisions for sustainable growth.

Moreover, it shows the Central government’s strong coordination with monetary policy despite fiscal dominance in developing countries like India.

However, some critics of inflation targeting feel that its sole focus on price stability ignores growth imperatives.

But the RBI Act rightly opted for maintaining price stability as its prime objective while giving due importance to economic growth. Data indicate that the real GDP growth did not decline during this period.

The five-year average real growth rate which was 6.50 per cent during 2011-2015, has increased marginally to 6.63 per cent during 2016-2019.

Improved transparency

Another aspect for which inflation targeting has been popular among emerging countries is monetary policy transparency. Monetary policy transparency in India has improved after the adoption of the inflation-targeting framework.

The Inflation Expectations Survey of Households (IESH) shows that the inflation expectation has been forward-looking in the post inflation targeting period in India. We find that inflation expectations do not depend much on its past information.

The lagged impact of past inflation expectations on current inflation expectations was significantly higher before the adoption of inflation targeting, but that lagged dependency has fallen in the FIT regime.

This suggests that households are increasingly using the current and future information to form inflation expectations. This implies that transparency in monetary policy is helping to reduce inflation expectations.

Importantly, to increase communication with financial markets and the citizens, the RBI is following international practices.

The frequency of the Monetary Policy Committee (MPC) meeting is set at six times per year, in line with most of the developed countries.

Like most countries, RBI takes two weeks to release minutes of the proceedings of MPC, which provides a forecast of CPI inflation and GDP growth. Further, every six months, the Reserve Bank publishes a Monetary Policy Report where it explains the sources of inflation and provides an inflation forecast for 6-18 months ahead.

To sum up, inflation targeting in India has been a success story. The RBI has toiled to achieve the credibility of a central bank that walks the talk and has rightly earned the goodwill and confidence of the financial markets around the world. This must not be thrown away and therefore, India must continue with the FIT regime.

The review committee should try to find out areas of further improvement in the monetary policy framework which will strengthen the MPC to achieve the inflation target.

In the present framework, it is not clear which model the RBI uses to forecast inflation and GDP figures, so it should disclose the models used in forecasting as other inflation-targeting countries do. Further, the RBI may include a forecast of core inflation in the minutes.

Sethi is an economist at the Fiscal Policy in Taxation, Bhuvaneshwar, and Dash is at Gulati Institute of Finance and Taxation, Trivandrum

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