Inflation targeting

Inflation targeting

Subject: Economy

Section: Monetary Policy

Context:

The world economy is currently passing through a growth-inflation configuration. The downside risks to growth have been accentuated globally for multiple reasons — low investments, high input costs, productivity slowdown, Ukraine crisis and related supply chain disruption, higher inflation due to ultra loose monetary policy

Challenges to monetary policy to control inflation

Inflation control being the overriding objective of monetary policy under the flexible inflation targeting regime, it would be difficult for the MPC to credibly pursue an accommodative monetary policy stance in the current situation:

• Inflation, mainly cost-push caused by supply chain disruption-Russia-Ukraine conflict and high crude oil prices are the two immediate factors contributing to upside risks to inflation.
• Fiscal-monetary conflict– as tightening monetary policy would increase cost of borrowing for government
• Crowd out effect of tight monetary policy- as cost of borrowing would rise leading to decline in private consumption and investment.
• Output gap is still negative– as output is below full-capacity production due to COVID pandemic.

Alternatives

• Drain out excess liquidity by selling foreign exchange when the rupee is depreciating.
• Pro-growth measure — a reduction in fuel taxes by both Central and State governments to neutralise the adverse impact of the rise in international crude oil prices on the wake of record collections in the GST.

Inflation Targeting

Inflation Targeting is a monetary policy framework wherein the Central Bank of a country focuses only on maintaining the rate of Inflation within a targeted range.

The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation.

Inflation targeting was first adopted by New Zealand and subsequently, a large number of countries including India have been following Inflation Targeting as their core element of monetary policy.

In case of India, the flexible Inflation targeting was introduced through the Monetary Policy Framework Agreement signed between the RBI and Government in 2015. As per terms of the agreement, RBI’s primary objective would be to maintain price stability, while keeping in mind the objective of growth. The RBI is required to maintain a rate of inflation of 4% with a deviation of 2% i.e. inflation has to be maintained between 2% to 6%.

The Reserve Bank of India Act, 1934 was amended to provide a statutory basis for a FTI framework. The amended Act provides for the inflation target to be set by the Government, in consultation with the RBI, once every five years.

Monetary Policy Committee

It is a statutory and institutionalized framework under the Reserve Bank of India Act, 1934, for maintaining price stability, while keeping in mind the objective of growth.

The Governor of RBI is ex-officio Chairman of the committee. The MPC determines the policy interest rate (repo rate) required to achieve the inflation target (4%).

Strict inflation targeting is adopted when the central bank is only concerned about keeping inflation as close to a given inflation target as possible, and nothing else.

Flexible inflation targeting is adopted when the central bank is to some extent also concerned about other things, for instance, the stability of interest rates, exchange rates, output and employment.

Accommodative and Tight Monetary Policy

To avoid inflation, most central banks alternate between the accommodative monetary policy and the tight monetary policy in varying degrees to encourage growth while keeping inflation under control.

• Accommodative monetary policy is adopted when central banks expand the money supply to boost the economy. These measures are meant to make money less expensive to borrow and encourage more spending.
• A tight monetary policy is implemented to contract economic growth. Converse to accommodative monetary policy, a tight monetary policy involves increasing interest rates to constrain borrowing and to stimulate savings.