Inflation debate: Current target holds merit, but 4% midpoint needs teeth

The Reserve Bank of India (RBI) has been following a flexible inflation targeting (FIT) approach since its monetary policy framework agreement (MPFA) with the Government of India in February 2015. The year-on-year inflation target of 4 per cent, with a tolerance band of 2  to 6 per cent, was announced in the Gazette on August 5, 2016. The new Section 45ZA in the amended RBI Act requires the government, in consultation with the RBI, to determine the inflation target in terms of the consumer price index (CPI) once every five years.

 

After the first quinquennial review, the validity of the target of 4 (±2) per cent was extended beyond March 31, 2021 to March 2026. Another review is due before March 2026. Two issues that have cropped up in this context are: (i) should the target be “core” rather than “headline” inflation, and (ii) should the target be revised upwards?

 

On the first tricky issue: Imagine yourself dissuading your spouse from buying tomatoes or carrots because of their high prices. The well-informed spouse asks you to stop the nonsense and shut up. They cite the “core” inflation figure and how the RBI has declared victory over price rise!  

 

Shifting from headline to core inflation will give the impression of an attempt to downplay the importance of food items and energy prices in the cost of living, and to lower the bar on the definition of price stability. If the old weight of food items in CPI is out of sync with the current family budget with higher incomes, the weight should be reduced appropriately, without making it zero. Furthermore, even the superiority of core over headline inflation in predicting future inflation lacks sufficient empirical evidence.

 

Now, the arguments in favour of revising the inflation target up from 4±2 per cent.  Let us look at our track record under FIT. India, a latecomer, adopted FIT after 32 countries — starting with New Zealand in 1989 — and it did so after sustained high inflation that averaged almost 9.5 per cent during 2010-2014. Under FIT, average annual inflation is down at 5.2 per cent in the last eight years (2016-2023), compared to 9.1 per cent during the preceding eight (2008-2015). No mean achievement, particularly because if 2008-2015 had the Great Recession to grapple with, 2016-2023 faced the challenge of the Covid-19 pandemic.

 

But how was the performance relative to what FIT had promised? Indeed, FIT did not promise 4 per cent inflation every month or even on average. It promised only inflation no more than 6 per cent for three consecutive quarters, and broke it only in the first nine months of 2019. Inflation breached 4 per cent — the mid-point of the inflation target band of 4 (±2) per cent — in 68 months, 22 months when it exceeded 6 per cent, and 46 months when it was between 4 and 6 per cent. Thus, inflation exceeded 4 per cent in almost 80 per cent of the months under FIT. Inflation was below the lower limit of 2 per cent only in four months of 2017, and average inflation during 2016-2023 at 5.2 per cent was well above 4 per cent. It is difficult to argue that India faced not too much, but too little inflation.

 

Had people concentrated on the fine print of FIT, they would have had no reason to expect inflation of 4 per cent on average per month.  But with FIT highlighting 4 (±) 2 per cent as the target, the mid-point of 4 per cent acquiring salience in people’s expectation cannot be dismissed as wholly illegitimate. If 4 per cent is of no significance, why not specify the target as 2-6 per cent, and not as 4 (±2) per cent?

 

There is merit, however, in not only sticking to the target of 4 (±2) per cent, but also giving the mid-point of 4 per cent some teeth. Should the RBI be required to submit an explanation if and when average inflation exceeds 4 per cent in three consecutive years? An average inflation rate of 4 per cent will help anchor expectations. With average world inflation at around 3.5 per cent (for example, during 2016-2023), it will prevent the appreciation of the exchange rate in real terms even when the nominal rate remains unchanged, and maintain India’s competitiveness in world markets.

 

How about the growth-inflation trade-off?  Empirical evidence of the old magic of the Phillips Curve — expansionary policy with higher inflation buying more growth — on a sustained basis is hard to find. In inflation-averse Indian polity, people complain about high inflation and high prices all the time. Thus, there may also be handsome electoral dividends from low inflation.

 

Then, there is the question of difficulties in maintaining low inflation amid fiscal dominance and political pressure to uphold an easy credit and low-interest-rate regime. Although the central government has historically exhibited a deficit bias, this trend appears to be on the wane. The fiscal deficit of the Central government, as a proportion of GDP, after doubling from 4.6 per cent in 2019-20 to 9.2 per cent in 2020-21 after Covid, has declined to 6.7 per cent, 6.4 per cent, and 5.9 per cent in the three subsequent years, and is budgeted to come down to 5.1 per cent in 2024-25. Furthermore, some researchers have found that more democratic political systems tend to have lower inflation, and political stability reduces the government’s inflationary bias. While these “deep” reasons should help in maintaining average inflation around the targeted 4 per cent, the RBI should also act as the government’s conscience keeper.

 

The author is a BJP member of the West Bengal Legislative Assembly and a former chief economic adviser to the Union finance ministry