The current inflation target has worked well
The inflation target of 4 per cent with a lower and upper tolerance level of 2 per cent and 6 per cent under the flexible inflation targeting framework is due for a review this month. India adopted the framework in 2016 and, according to the law, the Central government, in consultation with the Reserve Bank of India (RBI), is expected to determine the consumer price index-based inflation target once every five years. In this context, various stakeholders have suggested several modifications to the framework. Although the government will only review the target and not the overall policy framework, the experience so far is worth debating. The RBI has done well to publish a comprehensive study on the monetary policy framework in its latest Report on Currency and Finance.
The data shows that the new framework has worked well. Average inflation between October 2016 and March 2020 was 3.9 per cent, compared to 7.3 per cent in the preceding four years. Inflation volatility also came down during the same period, which means prices were comparatively stable. Several commentators have suggested that the RBI should be targeting core inflation because monetary policy measures are ineffective against food prices — it has about 46 per cent weighting in the CPI. However, it is important for the monetary authority to look at the overall inflation that consumers face. Neglecting a large part of the consumption basket may not serve the purpose. It will also affect expectations. The RBI neglected food inflation around the 2008 financial crisis, which got generalised and spilled over to non-food components. India is not an exception with a higher share of food items in the price index. In many emerging markets, food constitutes a significant part of the price index. This is one of the reasons why emerging markets tend to have higher inflation targets and wider tolerance bands.
Moreover, as the inflation rate went above the tolerance band in 2020, it was argued that the RBI should have more flexibility as the economy needed lower interest rates to overcome the Covid-related disruption. But a higher target or widening the tolerance band can result in higher inflation and increased volatility in prices, which will affect the ability of both firms and households to make longer-term decisions. Though it is not the official view of the RBI, the report has argued in favour of maintaining the current tolerance band. This is a sensible suggestion.
However, in the context of policy operation, the report notes that the marginal standing facility (MSF) and the fixed rate reverse repo are instruments of liquidity management. Therefore, the decision involving a change in the MSF and reverse repo rate may be shifted out of the Monetary Policy Committee (MPC) resolution. To anchor expectations, it can be said that in normal circumstances a symmetrical corridor will be maintained. This will be an unnecessary change and would affect confidence in the policy framework. The RBI did widen the liquidity adjustment facility corridor last year by reducing the reverse repo rate. Freedom to change rates at both ends of the corridor will undermine the standing of the MPC. If the economy needs lower rates, adjustments should be made through the MPC. In fact, this is one area where more clarity is needed. Change should only be driven by the idea of strengthening the policy framework.