National Council of Applied Economic Research
Opinion: Poonam Gupta:
In India, the inflation target (for CPI headline inflation) was set at 4%, with an upper tolerance limit of 6% and a lower limit of 2%. GoI constituted a six-member Monetary Policy Committee (MPC), including three ex-officio members from RBI with the RBI governor as its chairperson, the deputy governor in charge of monetary policy, and an officer to be nominated by its central board. The other three members were to be appointed by GoI for a non-renewable term of four years.
India moved to inflation targeting (IT) in October 2016, after experiencing double-digit inflation for several years. By doing so, it joined a growing group of more than 50 countries that adopted a similar framework to guide monetary policy. The framework has proven to be resilient and nimble, having survived global shocks including the Global Financial Crisis and Covid. There is no known case till date when a country has abandoned IT in favour of another framework.
In India, the inflation target (for CPI headline inflation) was set at 4%, with an upper tolerance limit of 6% and a lower limit of 2%. GoI constituted a six-member Monetary Policy Committee (MPC), including three ex- officio members from RBI with the RBI governor as its chairperson, the deputy governor in charge of monetary policy, and an officer to be nominated by its central board. The other three members were to be appointed by GoI for a non-renewable term of four years.
RBI was mandated to organise at least four meetings of the MPC annually. It was asked to publish a monetary policy report every six months to explain the sources of inflation and provide forecasts of inflation. It was urged to make publicly available the resolution adopted by MPC, the minutes of the meetings, the vote and statement of each MPC member, and a document explaining the steps to be taken to implement the MPC’s decisions.
Further, if RBI failed to achieve the inflation target, it had to submit a report detailing the reasons for this, the prospective remedial actions, and the estimated time period within which IT could be achieved. The agreement specified that RBI would be deemed to have missed its target if inflation exceeded 6% or declined below 2% for three straight quarters, and to have failed it when for three consecutive quarters inflation exceeded 6%.
Notwithstanding early misgivings, the IT framework has worked well. The constitution of MPC has been apolitical. Its meeting schedule has been posted in advance, and all its decisions and communications have been transparently articulated. Consequently, the suspense and surprises around monetary policy formulation have largely disappeared. RBI has not just maintained, but may have enhanced its independence since IT’s adoption. In other countries, the framework has curtailed the influence of the fiscal authorities, and achieved better coordination between the fiscal and monetary authorities. This seems to be the case for India, too.
Currently, the average inflation in India is much lower as compared to its previous trend rate, when it had averaged 10% during 2009-13. Inflationary expectations have been better anchored, and India has experienced a milder acceleration in recent months than in other comparative countries.
India has practiced a flexible IT framework. Evidence shows that the output gaps have not been neglected in policy formulation. MPC statements show that besides headline inflation and the output gap, MPC members assess a range of factors in their deliberations, including food inflation, agriculture sector, rural distress, unemployment, income inequalities, credit offtake, and the global environment. Along with the repo rate, a full policy toolkit comprising the liquidity adjustment facility (LAF) corridor, the cash reserve ratio (CRR), liquidity management, and communication is used. Thus, there is more continuity with the past frameworks than is often appreciated.
An early concern with IT was that an inflation target of 4% seemed too hawkish for a low-middle income country. Just like other countries, India targets inflation in a range, and has in-built escape clauses that allow temporary breaches. In its early years, MPC focused on strictly attaining an inflation target of 4%. Having established its credibility, it can now afford to periodically operate within the full range, while avoiding staying at either extremity of the range for long periods of time.
Ben Bernanke and Frederic Mishkin had argued in their 1997 paper, ‘Inflation Targeting: A New Framework for Monetary Policy?’ (bit.ly/3QUe3V8) that ‘inflation targeting does not represent an ironclad policy rule, as some writers on the subject and even some advocates of this approach seem to assume. Instead, inflation targeting is better understood as a policy framework, whose major advantage is increased transparency and coherence of policy, and in which fairly flexible, even ‘discretionary’ monetary policy actions can be accommodated.’ Inflation targeting has indeed operated in this spirit in India.
Now that the framework has stabilised, it seems to be the right time to tune down the frenzy around MPC meetings. The media, experts and RBI can turn their focus to other issues of critical importance, such as the management of the exchange rate, foreign reserves, capital account liberalisation, and regulation of banks and non-bank financial institutions. RBI ought to continuously revive its regulatory and policymaking capacity on all important issues, not just monetary policy.
The writer is director general, National Council of Applied Economic Research (NCAER)