Lens on inflation-targeting

Lens on inflation-targeting

Subject: Economy

Section: Monetary Policy

Context: Last week, the Reserve Bank of India (RBI) decided to stop raising interest rates. This was unexpected — since May 2022, RBI had consistently raised interest rates, trying to pull runaway inflation down closer to its target 4%level. India’s central bank is required by law to target a certain level of inflation. It does this primarily by raising interest rates in the economy. Higher rates slow down economic growth because loans of kinds become costlier. Thus, if any central bank were to focus relentlessly on targeting the inflation rate, the result could be an overall contraction in economic growth— in other words, a recession. In the United States, the Federal Reserve has been raising interest rates in a bid to achieve its target of 2% inflation. This is dragging down overall demand and economic activity, and there is a risk that the Fed might push the US economy into recession

What is runways inflation?

When inflation is uncontrolled (say in double-digit) and experienced over a long period of time, it gets the dreaded name of runaway inflation

Flexible inflation targeting regime

• 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.
• In case of India, the flexible Inflation targeting was introduced through the Monetary Policy Framework Agreement signed between the RBI and Government in 2015.
• 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.
• 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%.
• Under the flexible inflation targeting regime, the monetary policy decision making is vested with the Monetary Policy Committee but its implementation falls in RBI’s domain.
  • The Monetary Policy Committee (MPC) constituted by the Central Government under Section 45ZB of RBI Act determines the policy interest rate required to achieve the inflation target.
• When the Reserve Bank of India fails to meet the inflation target for 3 consecutive quarters, it will send a report to the central government stating:
  • A breach of the “tolerance level” for three consecutive quarters will constitute a failure of monetary policy
    • the reasons for failure to achieve the inflation target;
    • remedial actions proposed to be taken by the bank; and
    • an estimate of the time period within which the inflation target shall be achieved.
• These would be presented in a report to the Union Ministry of Finance.
• It would be up to the government to make the RBI report public.
• The special meeting of the MPC will discuss the RBI report before it is submitted.

Challenges to monetary policy to control inflation

• 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.

Rational Expectations?

• Rational expectations is an economic theory that states that individuals make decisions based on the best available information in the market and learn from past trends.
• Because people make decisions based on the available information at hand combined with their past experiences, most of the time their decisions will be correct. If their decisions are correct, then the same expectations for the future will occur. If their decision was incorrect, then they will adjust their behavior based on the past mistake.
• Increasing information–would help build expectations of low inflation by increasing credibility of the government and would help tame inflation in future.