Enthused by the slowdown in the rate of inflation (the Wholesale Price Index to 7.18% for December), the market is now expecting the Reserve Bank of India (RBI) to cut policy rates its 29 January monetary policy review. Inflation in India has been above comfort levels for almost three years now and RBI raised rates 13 times between 2010 and 2011 in order to check the pace of price rise before cutting it in April 2012.
Elsewhere, in Japan, the newly elected government is persuading the Bank of Japan, the Japanese central bank, to adopt a higher inflation target in order to get out of over two decades of deflation—persistent decline in the price level.
What is inflation targeting?
Inflation targeting became popular in the 1990s with many countries, including Canada and the UK, adopting it as the monetary policy framework. A lot of other central banks partially adopted inflation targeting along with other objectives such as output stabilization. In the inflation targeting framework, the central bank projects the trajectory of inflation in the medium term and attempts to bring it closer to the target level through tools such as interest rates.
In India, though, RBI does not target inflation explicitly, it has been the driving force for the monetary policy. The policy objective in the last few years has been to anchor inflation and inflationary expectations, which resulted in hike in interest rates and, arguably, is one of the reasons for slowdown in the Indian economy. Therefore, it is now being argued that the central bank should cut interest rates in order to support economic growth.
The recent global experience
Though the Federal Reserve in the US does not explicitly target a rate of inflation, the implicit target has been 2%. It has been argued that single-minded focus on inflation by the Federal Reserve under Alan Greenspan resulted in low interest rates for far too long and led to the creation of a bubble in the real estate market which ultimately turned into the global financial and economic crisis. Recent discussion in the domain of monetary policy is shifting towards “flexible inflation targeting”. Put differently, central banks are more willing to tolerate higher prices in order to boost output growth and employment. The Federal Reserve, for example, has stated that it will purse monetary easing till the unemployment rate comes down to the level of 6.5%.
The bottom line
Even though RBI has multiple policy objectives and despite the growing demand for rate cuts, higher inflation is expected to guide the monetary policy outcome.