National Council of Applied Economic Research
Opinion: Barry Eichengreen and Poonam Gupta.
Expanding the RBI’s mandate or shifting to a discretionary regime could undermine stability and prove counterproductive.
India adopted inflation targeting (IT) in September 2016. The government announced a 4 per cent Consumer Price Index (CPI) headline inflation target, within an upper limit of 6 per cent and a lower limit of 2 per cent. The inflation target and band are revisited every five years. The government constituted a six-member Monetary Policy Committee (MPC), consisting of three ex officio members from the Reserve Bank of India and three external members. The first MPC completed its term four years ago, and in September this year, a second MPC will complete its term.
For most part, IT has been successful. Inflation has declined, both compared to previous years and relative to other countries. Both CPI headline and core inflation have become less volatile. The transmission of policy has improved. Expectations of inflation have declined, indicating better anchoring.
IT has not caused the RBI to become overly hawkish or reactive to every deviation in inflation from its 4 per cent target. Since September 2016, the RBI has changed the key policy rate 17 times, the majority of them during 2019-20 and 2002-23. In the remaining six years, the policy rate was adjusted only about once per year. In contrast, the RBI changed the policy rate 24 times in the eight years prior to adopting IT.
Should the government then pay heed to the calls for modifying the approach to inflation targeting?
Broadening the Mandate?
Critics have opined that the RBI’s mandate to maintain price stability while also “keeping in mind the objective of economic growth” should be broadened to encompass other goals. Some say that the growth objective should be elevated so that it has parity with the price stability objective, similar to the US Federal Reserve’s dual mandate. Others have argued that the RBI’s mandate should be expanded to include the responsibility for developing the corporate bond market and the promotion of green finance.
In our view, giving too many responsibilities to the central bank risks diverting senior personnel’s time and focus from their primary duty of achieving price stability. It can overload and distort the conduct of interest rate policy and destabilise inflation expectations. A more complex mandate hinders central bank accountability by making it harder to evaluate its actions relative to its objectives.
Is Headline CPI Still Relevant?
Some have suggested that headline inflation is an inappropriate target, on the grounds that food prices are volatile, and focusing on them distorts the conduct of policy. They recommend that the RBI should disregard movements in food price inflation.
Our analysis indicates that food-price inflation feeds through to core inflation as producers mark up the prices of other products, and should not be disregarded. This is not to argue that the central bank should react to every movement in headline and food inflation. But neglecting food price inflation that diverges from target for an extended period can have adverse consequences.
Should the Consumption Basket be Updated?
The current basket accords a weight of 45.8 per cent to food and beverages. The basket has not been revised since 2011-12, even though per capita incomes have nearly doubled during this period.
The share of food in consumption declines as income levels rise. For example, a Bangladeshi spends 45 per cent on food, a Vietnamese spends 33 per cent; a Brazilian 24 per cent; and a South Korean spends only 14 per cent.
Our estimates suggest that the correct weight of food for India would be closer to 40 per cent. It would likely decline to around 30 per cent over the next decade, due to the projected increase in per capita income levels. This correction itself should ameliorate concerns on account of food inflation being part of the inflation target.
Is a 4 Per cent Midpoint Still Appropriate?
Other inflation-targeting emerging markets have reduced their point target for inflation as they gained experience with the regime and inflation came down. Compared to these other emerging markets, the RBI’s point target of 4 per cent is high. However, India is also a lower-income, faster-growing catch-up economy. Thus, a 4 per cent target is more appropriate for India.
But raising the target midpoint to, say, 6 or 8 per cent would not be a good idea either. A higher inflation target will adversely impact investment sentiment, will be regressive, will rebuild inflationary expectations and will erode the credibility of the RBI.
Should the Tolerance Band be Narrowed?
The RBI’s tolerance band of +/-2 per cent is wide by emerging market standards. It might be argued that allowing for relatively wide fluctuations of inflation weakens the anchoring effects of the regime and amplifies the volatility of expectations.
The fact that inflation in India is heavily weighted towards volatile food-price inflation militates against adopting a narrower tolerance band. In addition, if the world is now entering a period of heightened economic and financial volatility, keeping inflation within a narrow band will become more challenging and require wider, more frequent swings in interest rates. Such variations would create a less predictable climate for investment, posing challenges for economic growth.
Should Inflation Targeting be Abandoned?
Monetary policy must be organised around a nominal anchor, whether it be an inflation target, an exchange rate target, a target for the growth rate of monetary aggregates, or another benchmark. Inflation targeting has a better track record than these other options. In contrast to other monetary regimes, no country that adopted an inflation targeting regime has abandoned it subsequently.
Radical changes such as broadening the RBI’s mandate or abandoning the target in favour of a more discretionary regime would be risky and counterproductive. The regime can be tweaked to improve performance: The weight of food-price inflation in the CPI inflation basket should be reduced to better reflect the circumstances of Indian households, for example. Suitably updated, the current inflation targeting regime should remain the framework for the country’s monetary policy for the foreseeable future.
The writers are respectively, professor of economics and political science at the University of California, Berkeley, and Director General of NCAER. Views are personal.