RBI  paper  argues  for retaining  4%  inflation target

The inflation target is likely to be retained at 4% in the medium term, a Reserve Bank of India (RBI) working paper suggested on Monday. The paper, authored by Harendra Kumar Behera and Michael Debabrata Patra, goes beyond the stiff formality associated with central bank literature and veers into colloquialism, ending it by saying: “If it ain’t broke, don’t fix it”.

Patra, a deputy governor at the central bank, is also part of the monetary policy committee (MPC) tasked with keeping inflation within the flexible target of 2-6%.

The paper comes with the usual disclaimer that while the authors are from RBI, the views expressed are not necessarily those of the regulator.

Central to monetary policy, it said, is the concept of trend inflation to which actual inflation outcomes are expected to converge after short-run fluctuations die out. Accordingly, the inflation target needs to be fixed in alignment with trend inflation to avoid unhinging inflation expectations and flattening the aggregate supply curve or imparting a deflationary bias to the economy, it said.

“Results from a regime-switching model applied to a hybrid New Keynesian Philips Curve (NKPC) suggest a steady decline in trend inflation since 2014 to 4.1-4.3% just before covid-19 struck. This points to maintaining the inflation target at 4% for India,” the paper said. NKPC is a widely used model of inflation dynamics, according to a European Central Bank’s working paper from 2007.

Meanwhile, the paper by Behera and Patra argued that an inflation target set too much below the trend imparts a deflationary bias to monetary policy because it will go into overkill relative to what the economy can intrinsically bear to achieve the target. “Analogously, a target that is fixed above the trend renders monetary policy too expansionary and prone to inflationary shocks and unanchored expectations,” it said.

With India’s inflation as measured by consumer price index consistently remaining above RBI’s target since the outbreak of covid-19, experts have called for scrapping the target altogether. Bloomberg reported on 9 December that the government is considering recommending a looser inflation target for the central bank, allowing it to focus more on economic growth despite price pressures, citing people familiar with the matter.