INFLATION TARGETING – ECONOMY

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:

  1. In India, inflation is often driven by supply-shocks originating and operating through the food economy.
  2. Merely raising interest rates doesn’t help beyond a point; indeed, it is counter-productive.
  3. 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.
  4. 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.
  5. 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.
  6. Since, there are more lags in monetary transmission in India, over-shooting can have persistent deleterious effects here, including instability.
  7. Macroeconomic stability improves most rapidly if real interest rates are kept smoothly below growth rates and counter external shocks.
  8. The Indian economy is well-poised to achieve this combination and to reduce its chronic underemployment.
  9. Inflation is mainly driven by supply shocks and excess monetary policy reaction hurts the real economy.
  10. 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.