• The Reserve Bank of India (RBI) sought public feedback on whether its monetary policy should continue to target 4 per cent retail inflation or set new parameters to boost growth while maintaining stability in the fast-growing large economy.

• While emphasising that the flexible inflation targeting (FIT) regime has been successful, the RBI is also looking at whether core inflation would be the best guide for monetary policy.

Why RBI has released a discussion paper?

• Following a Monetary Policy Framework Agreement with the government in 2015, India formally adopted the inflation targeting framework in 2016. 

• The RBI Governor-headed six-member Monetary Policy Committee (MPC) determines the policy rate required to achieve the inflation target.

• The government has mandated the RBI to maintain a Consumer Price Index (CPI) inflation target of 4 per cent with a tolerance band of +/- 2 per cent during 2016-21.

• The same parameters were retained for the subsequent five years (April 1, 2021, to March 31, 2026).

• As per Section 45ZA of the RBI Act, 1934, the central government shall, in consultation with the RBI, determine the inflation target in terms of the CPI, once in every five years. 

• The central government initially notified the inflation target with the tolerance band on August 5, 2016, for the period 2016-2021. 

• In the first review conducted in March 2021, this target was retained for the subsequent five years till March 2026. A second review of the target is now due by end-March 2026.

• Against the backdrop of the next review of the target, and the significant changes in the global and domestic economic environment, the RBI has undertaken a review of the nature and format of the inflation target. 

• Towards this, it has come out with a discussion paper seeking feedback from stakeholders.

Inflation targeting

• Inflation targets may help provide a clear path for the medium-term inflation outlook, reducing the size of inflationary shocks and their associated costs. Since long-term interest rates fluctuate with movements in inflation expectations, targeting a low rate of inflation would lead to more stable and lower long-term rates of interest.

• Inflation targeting turns 35 this year. In 1990, New Zealand became the first country to formally adopt inflation targeting. Since then, it has become the most widely adopted monetary policy framework globally. 

• Despite practices preceding the formal theoretical structure, inflation targeting has steadily proliferated as a policy framework, gaining credibility and acceptance among central banks in both advanced economies (AEs) and emerging market and developing economies (EMDEs). 

• It has survived both national and global challenges such as the global financial crisis of 2008-09 and COVID-19 pandemic. 

• Globally, 48 countries, comprising 14 advanced economies and 34 emerging market and developing economies, have inflation targeting as their monetary policy framework.

• No major country that has adopted inflation targeting has ever abandoned it. Instead, the framework has been refined from time to time in line with the evolving domestic economic structures and the global landscape. 

• These revisions have been part of the framework reviews undertaken by central banks. 

• Conducted after due diligence, these revisions have generally tried to determine the right balance between the ‘rule’ and the ‘discretion’. 

• In a rule-based policy regime such as inflation targeting, the monetary authority conducts its policy-based on a pre-defined objective whereas in a discretionary set up, the policy maker could define its objectives

and priorities in line with the evolving economic scenario.

• The adaptability of the IT framework to evolving complexities through adjustments via framework reviews has enhanced its shelf life and acceptability. 

Arguments on whether to raise or lower the target of 4%

• The discussion paper said the inflation performance over the nine years of FIT witnessed a hump-shaped performance, with the first three years and the last three years remaining aligned to the target.

• The middle three years showed an inclination towards the upper tolerance band, confronted with a once-in-a-century pandemic followed by the Russia-Ukraine conflict that drove up the inflation trend worldwide during this period.

• Empirical support to the target of 4 per cent is also broadly provided by the Balassa-Samuelson effect that links real exchange rate changes through productivity differentials. 

• The Balassa-Samuelson hypothesis (1964) states that higher productivity growth in the tradable sector relative to non-tradable sector leads to higher aggregate wage growth in the economy. Thus, Balassa-Samuelson hypothesis provides an explanation for higher inflation in EMEs compared to the advanced economies (AEs), as the former generally experience higher output and productivity growth as compared to the latter.

• With an inflation target of 2 per cent for AEs, and estimated productivity differential of about 1.8-1.9 per cent between AEs and EMDEs including that of India, the Balassa-Samuelson effect suggests a desirable inflation of about 4 per cent for price stability. 

• In this context, reducing the target below 4 per cent (as witnessed in some other EMDEs) may not be appropriate in the case of India. 

• India being a fast-growing emerging economy faces the possibility of relatively higher services inflation following the Balassa-Samuelson effect. 

• In line with the global debate in the immediate post-pandemic period, a view was expressed to raise the inflation target in India as well. In this regard, based on threshold inflation estimates linked to fiscal and current account deficits, inflation close to 6 per cent rather than 4 per cent was considered optimal for India. 

• The argument was that growth costs of low inflation targeting (4 per cent) may outweigh the benefits of the current inflation target.

• However, raising the target at this stage — when the global economy is confronted with geopolitical uncertainty and geo-economic fragmentation — can be interpreted by global investors as a dilution of the IT framework thereby undermining policy credibility.

• It could erode the gains in policy and institutional credibility achieved through fiscal responsibility and external stability.

• There is also an argument to lower the target based on peer EMDEs experience. Emerging market economies like Indonesia, Brazil and Thailand have lowered their inflation target – Indonesia from 6 per cent to 2.5 per cent, Brazil from 8 per cent to 2.5 per cent, while Thailand has narrowed its target range over time. 

• When compared with these economies, our 4 per cent target remains higher. 

• The counter argument, however, could be that relative to these economies, India is a fast-growing catch-up economy with higher services sector inflation justifying a slightly higher target.

• Overall, there are arguments on both sides as to whether to raise or lower the target of 4 per cent.