Reconsidering the 4% inflation target

In determining the inflation target, there appears to be a trade-off between overcoming the zero lower bound problem and improving welfare

The prevailing monetary policy over the macroeconomic cycle is actually an implicit counter-cyclical fiscal policy. Photo: Abhijit Bhatlekar/Mint
The prevailing monetary policy over the macroeconomic cycle is actually an implicit counter-cyclical fiscal policy. Photo: Abhijit Bhatlekar/Mint

The Reserve Bank of India (RBI) targets a 4% inflation rate. Why? To understand this, consider the US experience first.

The Federal Reserve appears to target a 2% inflation rate. It is a positive rate because there can be wage-price rigidities that may be overcome by maintaining some inflation at, say, a 2%. This also gives the Fed room to reduce its nominal interest rate in a recession. To understand this, suppose that the real interest rate is 1.5% in normal times. Then the nominal interest rate normally would be 3.5% (2 plus 1.5). In this example, in a recession, the Fed can reduce the nominal interest rate by 3.5 percentage points before it hits the zero lower bound (ZLB). In practice, after the Great Recession hit the US around 2007, the Fed was constrained as it hit the ZLB quite soon. An important lesson is that it helps to have an inflation rate higher than 2%. Olivier Blanchard, then at the International Monetary Fund, suggested a target of 4% for the US going forward.

In this context, it appears that the RBI is better placed than the Fed has been. Indeed, the RBI chose the target of 4% inflation in the aftermath of the US experience; it may have been influenced by that experience though there can be other reasons as well. It is true that fluctuations in the prices of food and oil can matter more in India than in the US. This, it may be argued, warrants a high inflation rate target.

However, trade and flexible tariff policy, domestic fiscal policy, support prices and the public distribution system can be used to stabilize these prices over time. In any case, fluctuations are more an argument for greater flexibility around the targeted inflation rate rather than for a higher inflation target itself. The 4% inflation target in India, though lower than the average inflation rate in the past, is still a high rate; it can hurt the less well-informed public on an ongoing basis.

Also read: Headline CPI eases; core inflation sticky

In determining the inflation target, there appears to be a trade-off between overcoming the occasional ZLB problem, and improving welfare more generally. This is indeed true, under the prevailing policy regime. However, this is not the case under a different policy regime. Before considering this, let us re-examine what is already familiar.

The prevailing policy regime

When the RBI lowers the interest rate in a recession, it reduces the interest income of saving households. Also, it reduces the interest cost on borrowings by firms; the borrowings may be used for real or financial investments. The low interest-rate policy is effectively a policy of an implicit tax on saving households and an implicit subsidy for investing firms. So, there is redistribution from households to firms at a time when unemployment can be high.

Next, consider a boom; the policy here is to increase the interest rate. This acts as an implicit subsidy for saving households and as an implicit tax on investing firms. This acts as a reverse but effectively milder redistribution from firms to households in a boom.

Observe that the prevailing monetary policy over the macroeconomic cycle is actually an implicit counter-cyclical fiscal policy.

The proposed policy regime

Consider an explicit tax-subsidy scheme by the government of India (GoI). In a recession, it is proposed that the GoI should give an explicit subsidy to firms on the interest cost incurred on real investment. In a boom, the GoI should impose an explicit tax on firms on the interest cost on real investment. The purpose is to encourage real investment in a recession and vice versa. Given that there is both an explicit subsidy for firms in a recession and an explicit tax for firms in a boom, there is an inter-temporal balance in GoI’s budget for macroeconomic stabilization.

The proposed policy regime is obviously a case of explicit counter-cyclical fiscal policy. Unlike the usual taxes and subsidies, the proposed tax subsidy for macroeconomic stabilization can be, by an amendment in the Constitution, run by an independent authority; this avoids political pressures.

Also read: Demonetisation and monetary policy

A comparison

The proposed policy regime, unlike the prevailing policy regime, does not involve any redistribution from households to firms. The proposed policy does not include any new subsidy beyond what is already prevailing; the attempt is, in fact, to make it transparent, scale it down, and target it better. It is for real investment only and not for both real and financial investments, as is the case with the prevailing policy. In any case, the proposed policy is not just about a subsidy; it is a tax-subsidy scheme over the economic cycle.

It is true that the prevailing policy is simpler to administer than the proposed policy (despite the computerization in administration). However, that administrative simplicity comes with disadvantages.

And what about the possible misuse? The prevailing policy is worse as the implicit subsidy is, by law, available for any borrowing and not just for real investment.

Putting the pieces together

In a recession, the traditional monetary policy (the implicit subsidy scheme) cannot be used once the interest rate hits the ZLB; this is not a constraint in case of the proposed explicit subsidy scheme. Even if the nominal interest rate is zero, the GoI can always pay out a subsidy to bring about a further effective reduction in the interest rate!

Given such feasibility, the RBI need not worry about whether or not it can reduce the nominal interest rate adequately. So, the nominal interest rate need not be high in normal times to begin with. Accordingly, the inflation rate targeted by the RBI need not be as high as 4%, given the proposed paradigm shift in macroeconomic policy.

Gurbachan Singh is an independent researcher, and visiting faculty at the Indian Statistical Institute, Delhi Centre.

Published with permission from Ideas for India (, an economics and policy portal.

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