Govt and RBI should fix potential policy risks to inflation
The government is reportedly planning to loosen the inflation tolerance band for the Reserve Bank of India (RBI), which is due for a review in March next year. Inflation has been running above the given target for several months and the fear is that a monetary policy response can affect the ongoing recovery. However, a new working paper by RBI Director Harendra Kumar Behera and Deputy Governor Michael Debabrata Patra has advocated maintaining the 4 per cent inflation target. Although the paper does not represent the official view, it will not be easy for the central bank to take a considerably different line. According to the law, the Central government has to determine the inflation target once every five years in consultation with the central bank. The paper evaluates the inflation trend, which is said to be central to designing and implementing monetary policy. It serves “the crucial purpose of a consistency check on the setting of inflation targets”.
If the inflation target is set much above the trend, actual inflation could move higher, affecting expectations, which can increase the risk premium in financial markets. An upward movement in trend inflation can affect the effectiveness of the monetary policy. Also, setting the target much below the trend could result in a deflationary bias and affect economic outcomes. The study further notes that fluctuation in inflation rates has reduced over time, especially after the adoption of flexible inflation-targeting. Although it has been on a declining trajectory, trend inflation is still above the target. This suggests that inflation expectations are not yet fully anchored. Once the expectations are well anchored, it requires minimal action to address deviations. In fact, inflationary pressures emanating from supply-side shocks tend to be short-lived if expectations are well anchored.
Besides, changing the inflation target despite the evidence that it has worked well will affect policy credibility. This could significantly push up trend inflation and increase the eventual cost in terms of loss of output. Thus, the paper rightly notes: “If it ain’t broke, don’t fix it.” While it is important for the government to preserve one of the most important reforms in recent years, it is also critical for the central bank to gauge the inflation trajectory more accurately as monetary policy works with a lag. The RBI clearly underestimated the current spike. It has been attributed to supply-side disruption and high margins, among other things. To be sure, the issue of supply disruption has been by and large addressed. It is also not clear how retail margins have increased at a time when demand and incomes have suffered significantly. The inability of the central bank to correctly gauge inflationary pressures could also affect policy credibility.
Furthermore, the central bank will need to determine ways to deal with goals that could be in conflict with the inflation-targeting mandate. The RBI needs to manage government borrowing, which can be assisted by abundant liquidity and lower interest rates. It also has the responsibility of managing currency, which can result in excess liquidity as is currently the case. These goals can at times take precedence, affecting the general price level, which can undermine the inflation-targeting mandate. Thus, apart from continuing with the target, the government and the RBI should also address potential policy risks to inflation.