Home / Opinion / Views /  The country must retain its inflation target of 4%

The Reserve Bank of India (RBI) working paper by Harendra Kumar Behera and RBI deputy governor Michael Debabrata Patra on inflation targeting has waded right into one of the world’s most vibrant policy debates, one between inflation hawks and dis-inflationists. The former believe that easy-money policies pursued after the West’s financial crisis of 2008-09 that have given way to printing money as a path out of the covid crunch will eventually lead to much higher rates of inflation than experienced by the developed world in the last three decades. On the other side are dis-inflationists who believe that the world has undergone a structural change—thanks to demography, technology and globalization—that has caused the ‘Phillips Curve’ to flatten in some economies. By this, they mean that a long-observed trade-off between growth and inflation, under which an accelerative economy would overheat after a ‘speed limit’, has lost its disruptive power. The US Federal Reserve has recently loosened its rules a bit on fighting inflation, but there is no reason for RBI to follow suit.

In their paper, Patra and Behera set out to identify an appropriate inflation target for India, and find that it is still 4%, the central aim of an explicit policy adopted by RBI in 2016 that is due for a review in March. “If it ain’t broke," they argue, “don’t fix it." Yes. Take the pre-pandemic record. Retail inflation was in the range of 4.2% from 2014 to 2019, less than half the average over 2007-14. If India’s steady decline in inflation is consistent with a flattening of the Phillips Curve, the paper asks, what must be the right target at this point in time? A target set lower than the trend rate will result in an ‘overkill’ of tighter money that would hurt the economy, say the authors, while a higher aim will expose it to inflationary shocks. It would be best then to target 4%, as before, with elbow room of plus or minus 2 percentage points to give policymakers some flexibility.

That will disappoint those who would have India abandon inflation targeting to let RBI determine its policy mix as the occasion demands. There are, however, two problems with this: a likely loss of both our central bank’s freedom and ability to manage inflation expectations. Prudent governments charge their central banks with an official inflation target, as India did in 2016, since it gives monetary policy both independence and direction: independence from government calls to lower rates ahead of an election and then let inflation rise to reduce the value of its debt; direction so that firms and other economic participants can base their calculations on relatively reliable expectations. Yet, an argument has arisen to ‘look through’ inflation in pandemic times, as raising rates in response right now will harm our nascent recovery. What this should translate to, though, is a tolerance of 6% inflation at most, with a pushdown planned for later. Another point to note, as the paper says, is that growth and interest rates may no longer be as tightly related as we often assume. Also, the West’s experience is not always of much relevance. India’s growth story is very different from that of the US, for example, where its 2% inflation target has been undershot for several years and retail prices did not seem to budge as money supply increased. In contrast, we remain vulnerable to inflation, with the poor its primary victims. Just as our fiscal authorities opted not to replicate the ‘print-and-spend’ playbook of the West, RBI’s monetary policy too must go by our own domestic logic.

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