In December 2020, a paper by senior RBI economists argued that flexible inflation targeting had been successful in achieving its objectives and cautioned against raising the inflation target for fear of upsetting expectations
By Sarthak Agrawal
Next month, the Centre will have the option to review India’s inflation targeting (IT) framework formulated in 2015. Currently, RBI is statutorily mandated to maintain inflation at 4% with a 2% deviation on either side being permissible. Many experts recommend that the government should grab this opportunity to give the central bank more room to focus on growth post Covid-19. Based on rigorous research conducted by economists on India’s new monetary policy framework, this article argues tampering with RBI’s targets would be misguided.
For many years, members of the PM Economic Advisory Council have criticised the Monetary Policy Committee (MPC) for keeping rates high longer than necessary. Post Covid-19, however, the MPC slashed the repo rate by 1.15 percentage points (ppts). Some economists feel that raising the inflation target by 1 ppt or allowing a wider band for inflation will pave the way for even more aggressive rate cuts. Those generally critical of the IT regime are also vocal for reform. They argue that inflation in India is primarily driven by supply-side shocks (oil price hikes or monsoon failures) and a demand-based framework in the form of IT can do little except hurt growth.
However, researchers at the World Bank have found that India’s MPC was initially overly reluctant to raise rates even though India’s macroeconomic performance demanded tighter monetary policy. More recently, although inflation remained higher than 6% over three consecutive quarters, RBI didn’t increase rates or intimate Parliament of what it was doing to bring inflation down, as is mandated under the governing Act. Clearly, this suggests flexibility in approach that is characteristic of India’s idiosyncratic regime.
Economists also find that inflation expectations have become more anchored since 2015. Thus temporary variations in inflation do not feed into its long-term expectations because economic agents trust monetary policy to intervene. In the coming months, if the government increases the benchmark inflation target to 5%, expectations might rise one-for-one without any growth impetus. This will make the job of reducing inflation that much harder.
Another suggestion for tinkering with the regime is made by this year’s Economic Survey. North Block economists suggest that the MPC should instead target core inflation—the CPI measure stripped of its volatile and arguably interest-rate-independent food and fuel components. However, since 50% of India’s consumption basket is dominated by these items, expectations of inflation will rise sharply if the MPC abandons taking their prices into account while formulating monetary policy. This will make the committee’s task of bringing down even core inflation that much harder. For the same reason, it was rejected as a target variable in 2015 and the fuller CPI measure was opted for.
Critics from the other end of the spectrum feared that allowing half of the MPC to be appointed by the Centre would compromise monetary policy’s autonomy. There was divergence amongst members’ views in 14 of 23 meetings between October 2016 and September 2020; my analysis of voting patterns reveals that five members were the usual outliers. Viral Acharya and Michael Patra, both RBI appointees, were more hawkish (inflation-averse) while Centre’s Ravindra Dholakia was the sole dove. Pami Dua and Chetan Ghate often voted in line with the RBI members, interestingly, both Central appointees.
Since the committee was reconstituted last year, all rate decisions have been taken by consensus. However, in October 2020, Jayant Verma—a new government-appointed member—voted against the MPC maintaining an accommodative stance until FY22. Even Ashima Goyal, a noted IT critic, has remained muted so far. It seems the Centre hasn’t stuffed the committee with economists who would unwisely do its bidding, reflecting both the present dispensation’s aversion to high inflation and the precocious strength of the institution. Thus, there are few good reasons to tamper with the prevailing regime. In December 2020, a paper by senior RBI economists argued that flexible inflation targeting had been successful in achieving its objectives and cautioned against raising the inflation target for fear of upsetting expectations. The Centre will do well by heeding their advice.
The author is University of Oxford-trained economist. Formerly, a researcher at Institute for Fiscal Studies