Thursday 20 July 2017

Inflation Targetting – Is India on the right track ?

Recently RBI rules have been amended and RBI has adopted inflation targeting as its monetary policy strategy. As per government notification an inflation target of 4% will be followed till March 2021. This article while revisiting the genesis of inflation targeting (IT) attempts to find out the benefits of IT for India and the challenges that India face in making IT successful.

Genesis of Inflation Targetting

Milton Friedman once said that inflation is anywhere and everywhere a monetary phenomenon (Fishers’s equation of exchange) and hence it is controllable by central bank . Pre 1970s was a period of fixed exchange rate and hence because of the principle of macroeconomic trilemma there were constraints on Central Bank in maintaining inflation . The early 1970s saw the breakdown of fixed exchange rate and a move towards managed exchange rates. Flexible exchange rates gave the monetary authorities the independence to using monetary tools for solving adverse economic shocks. In the mid 1970s many industrial countries resorted to money growth targets. Under this approach central banks sought to control inflation by aiming for intermediate target rates of monetary growth. However, this approach failed in achieving inflation targets as the relationship between M1 growth and inflation is not tight (mainly because of shifts in money demand).
It was realized that given inflation the prime target the policy should aim at targeting inflation, rather than money growth. Thus from 1990s there was a shift towards inflation targeting. Some economists believe that inflation targeting is an effective tool as it helped followers of inflation target to achieve low levels of inflation. But critics argue that low inflation was the result of global non-inflationary situation.

Benefits of inflation targeting for India

Prior to inflation targeting RBI used to target a host of indicators and this created uncertainty in markets. For example, in 2004 -07in order to prevent rupee from appreciation due to surge in foreign exchange inflow RBI lowered the interest rates . This led to credit boom and fuelled inflation as it was a pro cyclical measure.  Thus inflation targeting will act as a bulwark against discretionary monetary policy. The requirement of the monetary policy committee to publish reports after their meeting will further help in ironing out the wrinkles of uncertainities.

Challenges ahead

1)      Supply side inflation: The economic survey 2016-17 mentions that while headline inflation (as measured by CPI) has lowered but core inflation has increased. This reflects the persistence of supply side inflation in India. It is worth mentioning that inflation targeting can target demand side inflation and not supply side inflation. In view of this appropriate measures should be taken to solve supply side bottlenecks.

2)      Weak transmission mechanism: For inflation targeting to be successful the country needs to strengthen its transmission mechanism. For instance, lowering the interest rate at the time of low inflation may not have desired impact on the inflation in the event of existence of weak transmission mechanism .
3)      Paucity of data: India’s economy is mired in poor data.  For IT to be successful the quality of data needs to be improved. Also there should be willingness to revise the base year of CPI so as to ensure that it is a good representative of consumption expenditure.


Thus taking various aspects into consideration the recent announcement of RBI to move towards MCLR in a broader spectrum is a step in right direction because it will help in improving transmission mechanism. There is also wisdom in RBI’s mandate of targeting a band of inflation rather than a fixed rate as it will provide elbow room for reacting to short term economic problems without creating volatility in the market.

- Tanushree Dutta

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