Inflation Targeting

What is Inflation Targeting?
Inflation targeting is a monetary policy in which a central bank has an explicit target inflation rate for the medium term and announces this inflation target to the public. It will have price stability as the main goal of monetary policy
Inflation Targeting in India:
  • The central government confirmed the continuance of inflation targeting as a tool.
  • The “inflation targeting” regime came into force in 2016. Recently inflation targeting has been renewed for another five years.
  • Following this, the RBI will continue to target maintaining retail inflation within the band of 2% to 6%.
  • RBI will use the headline inflation to control the inflation as it reflects the prices of essential consumer goods.
  • Retail core inflation, is the inflation rate without taking into account the fluctuations in the prices of fuel and food items.
Why it is good?
  • It will lead to increased transparency and accountability.
  • Policy will be linked to medium/long term goals, but with some short term flexibility.
  • 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.
  • It also helps in avoiding boom and bust cycles.
  • If inflation creeps up, then it can cause various economic costs such as uncertainty leading to lower investment, loss of international competitiveness and reduced value of savings. This can also be avoided with targeting
Why it may be bad?
  • It puts too much weight on inflation relative to other goals.
  • Central Banks Start to Ignore More Pressing Problems.
  • Inflation target reduces “flexibility”. It has the potential to constrain policy in some circumstances in which it would not be desirable to do so.
  • Cost-push inflation may cause a temporary blip in inflation.
Why many people have criticised RBI’s role in inflation targeting?
Many have criticised the RBI’s mandate of inflation targeting because of its contradictory role.
  • RBI acts as a regulator to maintain financial stability and control prices in the economy by increasing interest rates. But this has a negative consequence on economic growth.
  • Also, RBI is responsible to boost the economy by reducing repo rates. Because Cheaper loans will make it easier for firms and governments to borrow and spend/invest thus leading to economic growth.
  • Between 2016 and 2020, many times RBI focused more on keeping retail inflation low by setting high interest. This has affected India’s economic growth.
What are the alternatives suggested to inflation targeting?
  • Instead of headline retail inflation, the RBI should focus on the retail core inflation rate. Because fuel and food prices often shoot up in the short-term due to supply disruption.
  • RBI should not be looking at retail inflation. Instead, it should look at wholesale inflation. Because RBI’s move to tweak interest rate affects the credit available to businesses. This, in turn, is affected by wholesale inflation, and not retail inflation.
  • RBI should neither use the wholesale nor retail inflation rate as targets. Instead, the RBI should create a Producer Price Index to suit the RBI’s need.
  • A singular focus on maintaining price stability will be counter-productive for a developing economy such as India. They argue that the RBI should be working with the government towards ensuring fast economic growth rather than focusing on inflation targeting. Their argument is that inflation targeting is not the only way to be prudent about macro-financial stability.
Inflation targeting has been successfully practiced in a growing number of countries over the past 20 years, and many more countries are moving toward this framework. Over time, inflation targeting has proven to be a flexible framework that has been resilient in changing circumstances, including during the recent global financial crisis. Individual countries, however, must assess their economies to determine whether inflation targeting is appropriate for them or if it can be tailored to suit their needs. This should not be seen as a panacea for all the problems

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