Should India modify its inflation targeting (IT) framework, or even abandon it completely? Several commentators have raised this question recently, ahead of an official review of the monetary policy framework due in March 2025. Without doubt, periodic policy reviews are important – that’s why they are mandated in the IT law. And it’s also true that policies can always be improved. But the big picture needs to be kept in mind, which in this case is that IT has succeeded beyond expectations, making it one of the most important reforms of the last decade. Going back on this reform or making substantial changes to "loosen" the framework would erode the credibility of the central bank, damage the economy, and backfire in a political sense. Let’s consider how.
Before going into the debate, it is important to recognise what the upcoming review entails. According to the amended RBI Act, "the Central Government shall, in consultation with the Reserve Bank of India, determine the inflation target in terms of the Consumer Price Index, once in every five years". Strictly speaking, this refers to the numerical target of 4 percent with a band of plus or minus 2 percentage points on either side. However, this instruction can also be interpreted more broadly. Hence, the debate triggered by the Chief Economic Advisor needs be taken seriously. If some of the changes proposed are adopted – in particular, the suggestion that the RBI target only a subset of the CPI, excluding food prices--they would soon have enormous impact on the public.
Three points are worth noting in the context of this debate.
First, it is important to remember why IT was implemented in the first place. During 2009-2012, the UPA-2 government let inflation go out of control. CPI inflation reached 15 percent in March 2010, the highest among all the major G20 countries. And yet no one was held responsible, because the RBI was following a “multiple objectives” approach, under which it wasn’t firmly committed to any particular target. The resulting public outcry was so strong that the UPA was voted out of office (for this and other reasons) and a new government voted in, which pledged it would not allow such an episode to occur on its watch. To make this promise concrete, it enshrined IT into law.
Second, the reform has proved successful, far more so than many people anticipated at the time IT was adopted. The RBI has generally kept inflation within the 4-6 percent band; even when inflation has breached the upper limit, the deviations have been modest. Notably, inflation has never gone back to double digits, despite the serious food, oil, and pandemic shocks of the last few years.
Third, this success has brought benefits, both economic and political. Price stability has helped fuel growth, because it has allowed businesses to plan without worrying too much that their projections will be upset by surging costs. It has also reduced interest rates because it has improved central bank credibility, meaning that the RBI no longer needs to raise interest rates by as much as it did in the 2010s to convince people that it is serious about tackling inflation. Recent research conducted by Vaishali Garga, Aeimit Lakdawala and myself shows that market participants view RBI’s commitment to IT as credible. And price stability has paid political dividends, or at least allowed the NDA to avoid the political costs of high inflation suffered by the UPA.
But what about the argument that the RBI should narrow its target, to exclude food prices which it cannot control? The problem is this is a theoretical argument. And in the end, the theoretical points are not relevant. After all, the purpose of a government is to provide services that the public needs and desires. And the Indian public has made it clear that it desires price stability. Not for a subset but for its entire consumption basket, especially including food. Put another way, there’s a reason why all major central banks target inflation. And there’s a reason why they all include food in their target indices. Because it is what the public wants, indeed demands.
That said, there are indeed theoretical factors that the RBI cannot ignore. Central banks worry about rising food prices because of what is referred to as “second-round effects” such as the spillover of food inflation to non-food inflation through a wage-price spiral. Workers faced with higher food prices, demand higher wages in order to compensate for their rising cost of living and this in turn pushes inflation up even more. Some commentators have argued this consideration does not apply in India, noting that recent food price increases have not had any spillover. That may be true, but again is irrelevant, as it confuses the particular for the general.
In recent months in India, declining core (non-food, non-fuel) inflation implies that the second round effect is weaker right now. This is because there is pervasive unemployment in the economy. When there is surplus labour or a lack of adequate jobs, as is the case now in India, the workers are not in a good position to demand. They have less bargaining power to demand higher wages when food prices go up. In such a situation the wage-price spiral may not get triggered and hence we are not seeing steep increases in non-food inflation. But in the mid 2000s when the economy was booming and the labour market was tight, high food prices set off a wage-price spiral. This situation could easily recur if the economy grows rapidly over the medium-term, in which case changing the framework to tell the RBI to ignore signals from rising food prices could prove disastrous.
What is instead required is for the RBI to strengthen its analytical framework, given that its inflation and growth forecasts have frequently been subject to large errors. This in turn requires improving the underlying data, especially the CPI and GDP, which are outdated and have methodological issues. And it also requires a better understanding of agriculture, to assess whether food inflation is temporary or a reflection of some deeper, structural issues.
Implementing reforms in a messy democracy like India requires years of work and discussion. Even after a decade, the IT framework is still in its nascent stages and is being put to test by various shocks. It’s important to let it mature, making incremental rather than major changes that would endanger the overarching goal of price stability. As they say: if it isn’t broken, don’t fix it.
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