Inflation targeting

It should be followed and communicated properly

Containing inflation and managing inflation expectations have perhaps become the biggest challenge for policymakers across the world. The inflation rate in the US, for instance, climbed to a four-decade high in May. The Federal Reserve is tightening monetary and financial conditions to contain inflation and its potential action is now widely expected to push the US economy into recession. In the given economic backdrop, despite risks to output, containing inflation is the Fed’s top priority. The Indian policy establishment is also grappling with higher inflation. While the government has imposed various export restrictions, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) is raising interest rates. The inflation rate, nonetheless, is expected to remain above the tolerance band in the current fiscal year. This means the rate will remain above the tolerance band for three consecutive quarters and be treated as a failure to attain the target.

Although the recent surge in inflation is because of the Ukraine war, it has been argued, including by this newspaper, that the RBI waited for far too long to start unwinding excessive monetary accommodation. One of the critical points in this context is that communication from the central bank suggested it was comfortable till the rate was below 6 per cent — the upper end of the tolerance band — which affected expectations. It appears that’s been the thinking in the broader policy establishment. In an interview to this newspaper, Union Finance Minister Nirmala Sitharaman, for instance, noted: “Even if it [inflation] is well within 7-7.9 per cent or well within 8 per cent or 9 per cent, it is not any sacred number, whereas 6 per cent is a sacred number for me. We still want to bring it down to somewhere close to 6 or below 6 per cent.”

It’s worth noting here that the target given by the government to the RBI is 4 per cent, with a tolerance level of two percentage points on both sides. The basic problem with deriving comfort from the rate being around 6 per cent is that it leaves absolutely no margin for error, and this is exactly what seems to have happened over the past few quarters. One of the biggest downsides of such an approach is it damages the credibility of the central bank, and this can push up the term premium in the bond market, directly affecting the government because it is the biggest borrower. Therefore, it is important for policymakers to work towards bringing the inflation rate closer to the target. However, if there is evidence to suggest that adjusting the inflation target will help attain higher sustainable growth in the long run, it should be done through due process.

Another criticism in this context is that the RBI made the MPC practically irrelevant by disproportionately reducing the reverse repo rate and flooding the system with liquidity, which contributed to higher inflation. The reverse repo, which has now been replaced by the standing deposit facility as the floor of the liquidity adjustment facility (LAF) corridor, is not within the purview of the MPC. Thus, in order to enhance confidence in the MPC and reiterate its commitment to price stability, the government should consider bringing the entire LAF corridor within the purview of the rate-setting committee. However, this would work only if the inflation target is followed and communicated properly.