2-6% retail inflation band has been working well since 2016, say economists

However, some want core to be monitored as well, MPC should be given leeway to choose target

While economists believe that the current framework of retail price inflation at four per cent with plus and minus two per cent as tolerance limit has worked well, they say core inflation should also be monitored, with the government and the Reserve Bank of India set to review the target this month. 

However, some economists, such as Madan Sabnavis of CARE Ratings, are of the view that the target be changed to five per cent, plus or minus two per cent and it was clearly mentioned in the law that economic growth should also be a part of the target. 

For most of 2020, the consumer price index-based inflation rate remained above the upper target of six per cent, but the RBI's monetary policy committee (MPC) followed an accommodative policy, at least in the initial part of the lockdown, to prop up dwindling economic growth rate. This gave rise to calls that the current framework should be altered to allow for pro-growth policies at the time of downturn.

Former chief statistician Pronab Sen said the current framework is fine.

"But, I don't want headline inflation to be the only target in a country like India. I would prefer the second target, which would be the core," he said.

The core inflation relates to all items except food and fuel, as the two are quite volatile in nature.

Sen, who is now India programme director for the International Growth Centre (IGC), said core inflation should be targeted at three per cent plus minus one per cent.

Why does he think core is important?

To answer this question, Sen said, "At times when you have monsoon failure, taking decisions on the basis of headline inflation would be wrong because monsoon failure is a contractionary event. If on top of that you add further contractionary interest rates, you are becoming pro-cyclical, while you need counter-cyclical policies during such times."

If food prices are rising because income distribution has improved then you need to temper that down, he explained.

"So, you have to choose which target to follow at any given time. It should be left to MPC to decide rather than tied down in the law," Sen suggested.

India Ratings chief economist Devendra Pant said inflation targeting has helped in reducing inflation.

"However, the key in inflation targeting is a forward looking inflation forecast. We should understand that policies aren't based on one month's inflation print, they are based on how inflation will go out in the medium-term. Whether the movement is due to base effect, or cyclical factors or it has become structural are important factors," he said.

Higher inflation due to high food prices sets in higher wage expectations which may lead to higher inflation as a second round effect, he said. "This is the reason for headline inflation being used instead of core inflation. The 2-6 per cent range is most likely to be retained," he said.

Icra principal economist Aditi Nayar said,"In our view, the upper end of the inflation target band should be retained at six per cent to avoid an unanchoring of inflation expectations."

Shubhada Rao, founder of QuantEco Research, said the current framework has served well to anchor inflation and inflation expectations. "It is imperative that the inflation band be retained to not just anchor inflation expectations but for overall macroeconomic stability," she said.

However, CARE Ratings chief economist Madan Sabnavis said the range should be made five per cent, plus or minus two per cent. This meant an inflation target of five per cent and tolerance limit of three to seven per cent. He said ideally the target should include economic growth. But, whether the growth should be included in the target or not should be clearly mentioned and not left to the discretion of MPC, he said. 

Earlier, Principal Economic Advisor Sanjeev Sanyal had told Business Standard that the inflation target has worked reasonably well. He said the target range of 2-6 per cent does not require any major tinkering.

Recently, the RBI released the Report on Currency and Finance 2020-21, which suggested that the current mandate of 2-6 per cent inflation target for the monetary policy was appropriate and should continue for the next five years.

The RBI moved to an inflation-targeting framework in 2016. Since then, the six-member Monetary Policy Committee (MPC) has met 22 times, and the target has served the country well in anchoring inflation, argued the report.

Even as the foreword of the report has been written by RBI Governor Shaktikanta Das, the report is not the official view of the central bank.

The current law requires that in the case of the breach of the mandate of  keeping the CPI inflation rate in the range of two to six per cent for three consecutive quarters, the central bank has to send a report to the government, stating the reasons for failure to achieve the target; remedial actions proposed to be taken by it; and an estimate of the period within which the inflation target will be achieved.

In fact, CPI inflation remained over six per cent for the first three quarters of 2020 and in October and November as well. However, RBI escaped the scrutiny by the government because CPI for April and May was imputed. Imputation means prices of some groups are taken as substitutes of those of similar segments (and assorted accordingly) for which information is not available. This was the case due to lockdown in these months.

The target was valid till March 31, 2021, according to the RBI Act, amended through the Finance Act, 2016. That Act also brought in the Monetary Policy Committee (MPC) to achieve it through monetary policy. In one of its monetary policy statements, the MPC stated that since the National Statistical Office (NSO) did not provide the inflation rates for April and May but gave the imputed index, it is of the view that the CPI prints for these two months could be regarded as a break in the CPI series.