INFLATION TARGETING – ECONOMY
News: Lens
on inflation-targeting
What's in the news?
● Last
week, the Reserve Bank of India (RBI) decided to stop raising interest rates.
This was unexpected-since May 2022, RBI had consistently raised interest rates,
trying to pull runaway inflation down closer to its tar- get 4% level.
Key takeaways:
● India's
central bank is required by law to target a certain level of inflation.
● It
does this primarily by raising interest rates in the economy.
● Higher
rates slow down economic growth because loans of kinds become costlier.
● Thus,
if any central bank were to focus relentlessly on targeting the inflation rate,
the result could be an overall contraction in economic growth - in other words,
a recession.
Inflation targeting;
● Inflation
Targeting is a central banking policy that focuses on altering monetary policy
to attain a set annual inflation rate.
● Inflation
targeting is founded on the assumption that preserving price stability, which
is achieved by managing inflation, is the greatest way to generate long-term
economic growth.
● The
RBI is mandated to maintain a rate of inflation of 4% with a 2-percentage-point
deviation, i.e.inflation must be kept between 2% and 6%.
Inflation Targeting is a Double-edged sword:
|
Arguments for
Inflation Targeting |
Arguments
against Inflation Targeting |
|
Transparency and Accountability: It
will lead to increased transparency and accountability. RBI has to answer for
the following if inflation goes beyond the set permissible band = 2% to 6% (4%+/-2%).
Enhancing the predictability: Investors
and industrialists can predict the monetary policy decision in a better way
in the inflation targeting regime.
Perfectly shoot for managing boom and bust in the
economy: It
also helps in avoiding boom and bust cycles. Preventing economic Bubbles and
Fuelling Sustainable Growth. Inflation targeting can help avert disasters.
Set an ideal inflation which is good for the
economy: Inflation perse doesn’t affect the
economy. In fact inflation will fuel production and investment in the
economy. Inflation targeting helps to maintain the safe level of the economy
for economic prosperity.
Keep the inflation expectations low: With
inflation targeting in place, people will tend to have low inflation
expectations. If there was no inflation target, people could have higher
inflation expectations, encouraging workers to demand higher wages and firms
to put up prices.
|
Over emphasis on Inflation:
It puts too much weight on inflation relative to other goals like employment,
economic growth. Central
Banks Start to Ignore More Pressing Problems like unemployment.
Become counterproductive: Raising
interest rates just because of raising food prices, which is transitory, will
hurt the other sectors of the economy. It will reduce credit growth and
investment. And finally it lead to counterproductive against economic growth
Reduces the flexibility: Inflation
targets reduce “flexibility”. It has the potential to constrain policy in
some circumstances in which it would not be desirable to do so.
Not effective against supply side shocks: Inflation
targeting is not effective against Supply side constraints in India like food
shortages due to failure of rainfall. It cannot help remove supply
bottlenecks and shortages
Not effective against external shocks: It
cannot help external shocks, the exchange rate might suffer in the short run.
Example, rise in crude oil prices and global supply chain disruptions.
Failure in recent years: The
RBI has been off-target (4%) for a very long time. The notion that inflation
targeting works in India is a failure.
Exchange rate volatility:
Inflation targeting can lead to exchange rate volatility, particularly in
countries with open economies, as changes in interest rates can affect
capital flows and exchange rates.
Socio-economic impacts:
Inflation targeting can have social and economic impacts, particularly on
vulnerable populations, as changes in interest rates can affect employment,
income, and other macroeconomic variables. |
Need for India to reconsider of Inflation target:
- In
India, inflation is often driven by supply-shocks
originating and operating through the food economy.
- Merely
raising interest rates doesn’t help beyond a point; indeed, it is counter-productive.
- Many
economists, such as Pulapre Balakrishnan of Ashoka University, have
repeatedly warned against the use of inflation-targeting by the RBI.
Because The RBI has been off-target (4%) for a very long time.
- In
developing economies, like India,often agriculture productivity faces
constraints and its growth is unable to keep pace with the rest of the
economy. As a result, agricultural prices rise. Raising interest
rates doesn’t help matters in such a scenario. The only way inflation can
be handled is by the government
increasing supply. In the short-term, imports are the only option.
- First,
raising real policy rates [that’s nominal interest rates minus inflation]
to reduce demand has a stronger effect on growth than it does on
inflation.
- Since,
there are more lags in monetary transmission in India, over-shooting can
have persistent deleterious effects here, including instability.
- Macroeconomic
stability improves most rapidly if real interest rates are kept smoothly
below growth rates and counter external shocks.
- The
Indian economy is well-poised to achieve this combination and to reduce
its chronic underemployment.
- Inflation
is mainly driven by supply shocks and excess monetary policy reaction
hurts the real economy.
- Excess
tightening would not improve [RBI’s policy] credibility if excess demand
due to supply-side deterioration causes inflation persistence
Inflation
targeting will ensure that there is transparency
in the central bank's role and the targets for inflation in the economy.
However, over a long period of time, it hinders the true potential of growth in
the economy as it throttles the growth to achieve
price stabilization. In extraordinary
circumstances such as the COVID pandemic, inflation targeting is not a
solution. Apart from Inflation, more indicators, like employment rate,
economic growth, investment, global price scenario, will be included while
setting a monetary policy.