Introduction to Inflation Targeting
Inflation targeting is a modern monetary policy framework used by central banks to achieve a specific annual inflation rate. This approach involves adjusting short-term interest rates to steer inflation toward the target rate, aiming to anchor public inflation expectations and ensure price stability. As a result, it supports sustainable economic growth and provides a clear direction for monetary policy. Many countries, including New Zealand and Canada, have adopted this approach since the early 1990s, and it is now used by around 45 countries and the Eurozone.
Why Inflation Targeting is Considered a Good Policy
Inflation targeting is considered a good policy for several reasons. Firstly, it promotes transparency and credibility by setting a clear numerical target, making a central bank’s actions more predictable and accountable. This enhances the public’s trust in the central bank’s commitment to controlling inflation. Secondly, it helps in anchoring expectations, allowing businesses, investors, and households to plan for the future with greater certainty, reducing economic volatility and supporting long-term planning. Lastly, it offers flexible discretion, enabling central banks to respond to economic shocks, such as a recession, by balancing the primary goal of price stability with other concerns like economic growth and employment.
India’s Inflation Story Since 2016
India adopted the flexible inflation targeting (FIT) framework in 2016, setting a target of 4% headline Consumer Price Index (CPI) inflation, with a tolerance band of ±2 percentage points (2-6%). The Reserve Bank of India’s (RBI) Monetary Policy Committee is responsible for achieving this target, primarily by adjusting short-term interest rates. Since 2016, India’s average inflation has been 4.9%, a significant improvement from the 6.8% average earlier. The framework is credited with stabilizing inflation and improving the effectiveness of monetary policy transmission.
The Great Food Debate
The RBI argues that headline inflation is more relevant to the average household’s cost of living, as food and fuel are major expenses. It believes that targeting a measure people directly experience helps anchor inflation expectations and builds credibility. However, critics argue that sudden shocks in these sectors, which are often beyond the central bank’s control, can push inflation outside the target band, potentially undermining the RBI’s credibility or forcing an overreaction in policy.
Global Practices and the Path Forward
While the US Federal Reserve’s official long-run inflation target is 2%, it doesn’t specify which measure it uses. In practice, however, it primarily tracks the Personal Consumption Expenditures (PCE) price index, paying close attention to both headline PCE and "core PCE" (excluding food and energy). The Bank of England and the European Central Bank follow a similar approach, focusing on headline CPI for their targets while constantly analyzing core inflation to understand underlying trends. As the RBI prepares for its next policy review, the feedback will help shape the future of India’s monetary policy, balancing the proven effectiveness of the current framework with the need for adaptability in a changing global economy.
Conclusion
In conclusion, inflation targeting has been a cornerstone of India’s economic stability since its adoption in 2016. The RBI’s discussion paper has sought feedback on whether to continue with the 4% headline target or shift focus to core inflation. While the existing framework has served India well, the central bank is open to refinements. The final decision will depend on balancing the proven effectiveness of the current framework with the need for adaptability in a changing global economy. One thing is clear: inflation targeting will remain a central pillar of India’s economic management. The writer is a professor at Madras School of Economics, and their expertise provides valuable insights into the importance of inflation targeting in India’s economic policy.
