Inflation Targeting

Context: The Reserve Bank of India’s 2023 monetary policy objective is to hold inflation within the mandated tolerance band and guide it towards the medium-term target of 4% by 2024, officials said in an article published in the monthly bulletin. 

Findings of the RBI report

  • The Reserve of India report stated that “with consumer price-based inflation (CPI) easing below the upper tolerance band of 6 percent, the focus for 2023 is to tether inflation at those levels and further align it to the target of 4 percent by 2024”  
  • The government has mandated the central bank to keep inflation at 4 per cent with a +/- 2 per cent band. 
  • The report said the country’s macroeconomic stability is getting bolstered with inflation being brought into the tolerance band. 
  • The report was prepared by RBI’s deputy governor Michael Patra and other RBI officials. The views expressed in the report are of the authors and not of the institution, the report said. 
  • Authors said the prospect of India as a bright spot amidst 2023’s encircling gloom is burnished by most recent history and current developments. By cross-country standards, the country’s economy exhibited resilience through 2022 in the face of the triad of shocks – war; monetary policy tightening; and recurring waves of the pandemic. 
  • The report said the country’s macroeconomic stability is getting bolstered with inflation being brought into the tolerance band. 
  • In April 2023, India’s population will be the largest in the world, projected at 1.4 billion. A sixth of the increase of the world’s population of working age (15-64) people between 2023 and 2050 will be Indians. 
  • “Coupled with a median age of 28, this is India’s chance to seize the demographic dividend and herald its emergence as an economic powerhouse of the future” the report said. 

What is Inflation Targeting?  

  • Inflation targeting is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation.   
  • The inflation target is defined as a medium-term average rather than as a rate (or band of rates) that must be always held.   
  • 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 primarily focuses on maintaining price stability but is also believed by its proponents to support economic growth and stability.   
  • Inflation targeting can be contrasted to other possible policy goals of central banking, including the targeting of exchange rates, unemployment, or national income.  

India’s Inflation Targeting 

  • In 2016, the Reserve Bank of India Act, 1934, was amended to provide a statutory basis for the implementation of a flexible inflation-targeting framework, where the Centre and the RBI would review and agree upon a specific inflation target every five years. 
  • Under this, 4% was set as the Consumer Price Index (CPI) inflation target for the period from August 5, 2016, to March 31, 2021, with the upper tolerance limit of 6% and the lower tolerance limit of 2%. 
  • MPC being accountable for failure to establish and achieve the nominal anchor. The failure defined as the inability to achieve the target of 4 percent (+/- 2 per cent) for 3 successive quarters. Such failure requires MPC to issue a public statement 
  • To the extent that ensuring price stability is its primary goal, the RBI through its MPC must constantly assess not just current levels of inflation and prices of various goods and services in the economy, but also take into consideration inflation expectations both of consumers and financial markets so as to use an array of monetary tools, including interest rates, to contain inflation within its target range. 

How does inflation targeting work?  

  • The central bank forecasts the future path of inflation and compares it with the target inflation rate (the rate the government believes is appropriate for the economy).   
  • The difference between the forecast and the target determines how much monetary policy must be adjusted.   
  • Some countries have chosen inflation targets with symmetrical ranges around a midpoint, while others have identified only a target rate or an upper limit to inflation. Most countries have set their inflation targets in the low single digits.   

Cons of Inflation Targeting  

  • A major advantage of inflation targeting is that it combines elements of both “rules” and “discretion” in monetary policy. This “constrained discretion” framework combines two distinct elements: a precise numerical target for inflation in the medium term and a response to economic shocks in the short term.  
  • Some analysts believe that a focus on inflation targeting for price stability creates an atmosphere in which unsustainable speculative bubbles and other distortions in the economy, such as that which produced the 2008 financial crisis, can thrive unchecked (at least until the inflation trickles down from asset prices into retail consumer prices).  
  • Some believe that it encourages inadequate responses to terms-of-trade shocks or supply shocks.   
  • Critics argue that exchange rate targeting or nominal GDP targeting would create more economic stability. 

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