Inflation Targeting Framework: Successes, Challenges & Way Ahead

Context (IE): Debate on whether India should modify/abandon its inflation-targeting (IT) framework.

What is Inflation Targeting?

IT is a monetary policy framework where the central bank explicitly sets a publicly announced target for the inflation rate and uses tools like interest rates to steer the economy towards that goal.
It acts like a “compass for price stability,” aiming to keep inflation within a specific range, ensuring predictable prices and fostering economic confidence.
Inflation targeting worldwide: While some countries have adopted point targets, others follow a more flexible approach to targeting inflation within a band. Inflation targeting has been adopted in many countries, including New Zealand, Australia, Canada, Finland, Israel, Spain, Sweden, and the UK.

Also, learn about > Types of Inflation.

Pros	Cons
Improve credibility & anchor inflation expectations, making economy investor-friendly.	Monetary policy actions take time to impact inflation, risking mistimed responses.
Provide a clear path for the medium-term inflation outlook, reducing the size of inflationary shocks.	It does not remove supply bottlenecks or shortages.
It enables businesses & investors to plan their investments and policies by considering inflation rate changes.	It may overlook asset bubbles or systemic financial risks while focusing solely on inflation.
It helps maintain a transparent monetary policy.	It may limit policy flexibility or constrain policy measures such as fiscal stimulus.
Informed IT have secured Indian banks from the spill-over effect of the Silicon Valley bank collapse.	Uniform inflation targets may not adequately consider regional disparities leading to potential imbalances and uneven development.

In the first two decades following independence, there was no formal framework for monetary policy.
From the 1960s to the mid-1980s, IT was described as “credit planning” during which policy operated via the statutory liquidity and cash reserve ratios.
Mid-1980s to late 1990s: RBI employed a “monetary targeting with feedback” framework, in which the broad money supply was aligned with projected GDP growth. Price stability was the central objective of monetary policy, with 5-7% as the target range for inflation.
The Urjit Patel Committee Report (2014) advocated for Flexible Inflation Targeting (FIT) and proposed a target of 4% inflation with a tolerance band of ±2%.
IT was introduced in 2015 through the Monetary Policy Framework Agreement between the Union Government and the RBI.
- In 2016, the RBI Act was amended, which gave statutory basis for Monetary Policy Framework and the Monetary Policy Committee (MPC). This made inflation targeting a legal mandate for the RBI.
Target: In consultation with the RBI, the government set an inflation target of 4% (CPI-Combined inflation) with a band of +/- 2% (i.e., between 2% and 6%).

Lower inflation volatility: Inflation in India has averaged 7.5% since the 1980s, except in the early 2000s when it averaged 4%. Inflation has declined since the adoption of IT, compared to the preceding years and relative to the average inflation of the world and low- and middle-income countries.

Credits: NCAER

Less volatility: Following the adoption of IT, the exchange rate, the stock market, and the call money rate, Yields on government debt have become less volatile. In contrast, the volatility of portfolio capital flows has not changed.
Increased investment: Price stability has helped fuel growth, allowing businesses to plan without worrying too much that surging their projections will be upset by surging costs. It has also reduced interest rates because it has improved central bank credibility.

Use of headline inflation as the nominal anchor causing “second-round effects” such as spillover of food inflation to non-food inflation through a wage-price spiral.
- The current CPI series is based on the 2011-12 consumption survey. Though updated in 2015, it still contains obsolete items like DVDs and audio cassettes.
Policy transmission lag: Transmission to bank lending rates and bond yields of longer-tenure securities is weaker and has not improved with the adoption of IT.
Growth vs Inflation Dilemma: Tight monetary policy to control inflation can stifle growth, especially during economic downturns, making it hard for the RBI to balance these competing objectives.

Strengthening the analytical framework of RBI, given that its inflation and growth forecasts are frequently subject to significant errors.
Improving the underlying data that is outdated and has methodological issues.
Better understanding of agriculture to assess whether food inflation is temporary or a reflection of some deeper, structural issues.
Strengthening monetary policy transmission to ensure that changes in policy rates are effectively transmitted to the real economy, promoting the desired inflation outcomes.
Enhancing coordination between monetary policy and fiscal policy to achieve a harmonised and effective approach towards managing inflation and promoting economic stability.