Introduction to India’s Monetary Policy
The effectiveness of monetary policy in India’s pre-inflation targeting regime was constrained by several factors, including sustained fiscal dominance, a large informal sector, and bank behavior in pricing loan products. However, the government, the Reserve Bank of India (RBI), and banks have made significant efforts to address these issues over the last decade.
The Flexible Inflation Targeting Framework
In February 2015, the RBI adopted the flexible inflation targeting (FIT) agreement, which was later amended in May 2016. The inflation target was set at 4% with an upper tolerance limit of 6% and a lower limit of 2%. This band has remained unchanged since its introduction.
Performance of the FIT Framework
A review of the FIT performance over the past 10 years reveals that inflation has declined since the adoption of inflation targeting. Both core consumer price index (CPI) and CPI inflation have stayed within the band of 2-6% with a few exceptions. The FIT performance in the first five years, which included the Covid-19 pandemic, exceeded the inflation target due to supply shocks and liquidity creation. However, both core and CPI inflation have stabilized close to the upper band since then.
Effectiveness of the FIT Framework
The FIT framework has been effective in anchoring expectations and insulating the economy from external fluctuations. The flexibility in inflation targeting, as practiced by the RBI, has worked well in India. This approach allows for uncertainties in forecasting and lags in the effects of monetary policy on the economy. The inflation target is forward-looking, enabling monetary policy to play a role in dampening output fluctuations over the course of the cycle.
Comparison with Other Economies
India’s average inflation since the introduction of inflation targeting is 4.9%, while food inflation is also remarkably low at 4.9%. Compared to advanced economies like the US, Germany, and France, India has had one of the lowest deviations from its inflation target in the triennial average inflation from 2021-2024.
Future of the FIT Framework
The question of what should be the future of the FIT framework after 2026 has sparked debate. Some propose continuing with the current regime, while others suggest targeting core inflation instead of overall CPI. However, targeting core inflation may not be suitable for the Indian economy, as it may accentuate cross-subsidization between households and sectors.
Revision of the Inflation Target
Another possibility is revising the mid-point inflation rate or narrowing the band further. However, the statistical evidence suggests that the current regime has delivered, and it may be best to continue with it. The argument that food inflation remains sticky, but core inflation has moved down, is counterfactual. Inflation targeting by the RBI has anchored inflationary expectations, reducing the spillover from higher food to core inflation.
Conclusion
The FIT framework has achieved the required credibility, and any changes to it must ensure continuity and ease of communication. The current target of 4% with a variation of +/- 2% is appropriate and may continue till 2031. Drastic revisions to the FIT framework could be counterproductive, especially during a time of high policy uncertainty. Therefore, it is essential to maintain the current regime and continue to communicate the inflation target effectively to anchor expectations and ensure the stability of the economy.
