Is Flurry Against Inflation Targeting in India Justified?

Context: The debate over the suitability of flexible inflation targeting (FIT) for India has again gained momentum as the Reserve Bank of India (RBI) is to continue with its Consumer Price Index (CPI) inflation target of 4% +/-2% for the next five years.

Overview of Inflation Targeting in India

• India adopted a formal Inflation Targeting Regime in 2016.
• The new policy framework was an outcome of the Urjit Patel (2014) committee report which advocated for formal inflation targeting regime.
• The new regime constituted a monetary policy committee which was authorized to determine policy rates and provided with a legal mandate of keeping inflation at 4% (+/- 2%)

Key claims against the FIT regime in India:

• FIT led to higher than desired real interest rates, with adverse consequences for economic growth, in recent years.
• No effect of policy: Moderation in inflation under the FIT regime is almost exclusively due to a consistent decline in global inflation and slower increases in minimum support prices for farm produce and should not be attributed to the policy shift.
• The trend of inflation in India had begun to decline even before the FIT introduction.

Counterfactual evaluation of the above arguments:

• Other factors also lead to higher real interest rates: and thus should not only be attributed to the FIT.
• Errors in economic forecasts stem from imperfect forecasting models, incomplete information or misinterpretation of the state of the economy, unforeseen events such as demonetization, sudden and frequent changes in tax structure (goods and services tax) and changes in the prices of volatile items like food and fuel.
  • RBI's forecasts released in the public domain appear to be based on a technical assumption of an unchanged repo rate during their duration. 
    • Changes in the repo rate this month and its likely transmission into higher actual inflation two years ahead is not inbuilt in the current forecast.
• Role of luck: The RBI, in its Report on Currency and Finance 2020-21, acknowledges the role of luck. For E.g. rise in the global oil prices may lead to the missing of inflation targets.
• Role of structural factors in declining inflation: While inflation was already declining before the FIT regime started, it was more because of structural factors like unresolved bank crisis.
  • Given these factors, lower real interest rates and higher liquidity may have been insufficient to spur economic expansion.

Way forward:

• FIT is the credible alternative: Abandoning the FIT regime would do more harm to India's growth prospects and stability than aid it.
  • The RBI experience of 2009 shows how multiple objectives and indicators can lead to a policy error.
  • Inflation targeting should be viewed as a policy strategy that "constrains the central banks from systematically engaging in policies which have undesirable long term consequences but which allows discretion for dealing with unforeseen or unusual circumstances".