Economy
Does the 4% inflation target need a reset?
Summary
- Since April 2021, inflation has exceeded 6% more often than not. Several other countries have also struggled to bring inflation down to their target levels. If India’s optimal inflation rate has moved beyond the earlier 4% mark, it could be time to revisit the goalpost itself
Inflation is back. Just when we thought it was effectively contained within the official upper bound of 6%, the consumer price index (CPI) shot up by 7.4% year-on-year in July 2023. This inflation persistence is quite a letdown, especially when growth is finally showing signs of picking up. But look beyond the headline-grabbing tomato and onion prices, and it is clear that inflation never really went away. The last time inflation was at or below the Reserve Bank of India’s (RBI’s) 4% target was in September 2019.
This problem is not unique to India. Other countries are also struggling to bring inflation down to their target levels. The tenacity of inflation despite more than a year of monetary tightening has led experts to question whether inflation targets need to be raised to better reflect new realities. In the US, for instance, a 3% target instead of the current 2% has been suggested. The same question can be asked about India.
India adopted flexible inflation targeting in 2016, and an inflation target is set every five years. In March 2021, the government retained the target at 4% headline CPI inflation for April 2021-March 2026, with lower and upper tolerance limits of 2% and 6%, respectively. Seeing that inflation has been higher than 6% anyway for more than half the number of months since April 2021, should India adopt a higher official target? This question is best answered by examining the current flexible inflation targeting framework in terms of the target rate, the tolerance band and inflation expectations.
Trend inflation
Trend inflation is the rate to which inflation converges in the long term. In theory, it is the inflation consistent with optimal GDP and stable employment rates. RBI studies have shown that India’s trend inflation was around 4% in early 2020. But the trend changes over time in response to structural changes in the economy, which is why estimating—and re-estimating—trend inflation is key to effective monetary policy.
If the inflation target is above trend, monetary policy will turn expansionary, creating inflationary conditions. If the target is set below the trend, monetary conditions may be too tight, restricting growth. The aim is to steer the economy towards the Goldilocks trend—the “just right" stage. It is too soon to tell if the impact of supply-chain disruptions and the Ukraine war will be transitory. If it is, inflation should return to the pre-pandemic 4% trend, else the new trend level may need a reset of the inflation target in due course.
Finding the threshold
Among emerging economies, India has an unusually large 2% inflation tolerance band on either side of the 4% target. This was adopted for two reasons. One, the high weight of food in the CPI basket increases the volatility. Two, the price of fuel depends on external factors, but impacts CPI significantly. Food and fuel price fluctuations cannot be ignored because they tend to quickly pass into general inflation. A relatively wider tolerance band gives the RBI the flexibility to stay within official limits during periods of volatility.
Households and businesses can usually deal with moderate inflation, but there is a threshold beyond which their budgets get impacted. RBI research shows that India’s long-term economic growth is impaired when inflation crosses 6%. At a more general level, a comparison of Google search trends for “inflation" against actual inflation trends reveals a higher sensitivity to inflation for thresholds above 6%, suggesting that it may be a sound upper bound for policy action.
The reset moment
A realistic inflation target with the right tolerance limits will keep inflation expectations well-anchored. In other words, long-term expected inflation should not move far from the target. A good way to check this is to look at the RBI’s bi-monthly survey of professional forecasters. Results show that short-term expectations went up in 2022 as inflation rose, but longer-term expectations were anchored in the 4%-5% range. This is probably a reflection of trust in the RBI’s ability to manage inflation.
This “credibility bonus" that the RBI earned during the low inflation years of 2016-2019 is important, because this reputation allows it to target inflation with relatively smaller tightening actions. But to retain its credibility, it is vital that the target be raised, if at all, after inflation has been brought firmly under control. Moving a goalpost because it cannot be reached is a sign of desperation, not wisdom.
(The author is an independent writer on economics and finance.)
