Re-evaluating Inflation Targeting

Context: A critical analysis of the claims regarding the success of flexible inflation targeting in India.

Evolution of Inflation Control:

• Globally, in?ation control became de rigueur after the high in­flation that followed the oil shock in the early 1970s. (Brought in by Milton Freidman who suggested monetary-supply targeting)
• In India, poli­cymakers had engaged with in?ation since the 1950s, when plans to industrialise met the challenge of in?ation.
• In 2016, an agreement was signed between the Central Government and the Reserve Bank of India to keep the inflation rate in the prescribed band of 2-6%.

Significance of Inflation Targeting:

• Kept the inflation in check: the inflation rate had remained within the prescribed band of 2% to 6% since 2016 when in?ation targeting was introduced
• Successful Inflationary Prediction: the RBI has suc­ceeded in anchoring in?ationary expectations.

Concerns over the efficacy of inflation targeting

• Natural rate of growth is unobservable: Since this model revolves around the proposition that in?ation re?ects “overheating”, or economic activity at a level greater than the “natural” level of output.
  • Central banks have kept interest rates too low, at a level lower than the “natural” rate of interest.
• Not statistically validated with Indian data: For e.g., While the inflation was already between the 2-6% band before 2016, it has steadily declined, halving by 2015-16.
  • This by itself suggests that there is a mechanism driving inflation.
• Conflicting patterns with other variables:
  • Economic growth: Began to decline since 2010-11, and low inflation and falling interest rates couldn’t help in reviving growth prospectus.
  • Investments: Private investment rate continuously declined despite the low inflation period, which is considered conducive for investments.
  • Exports and employment: Fared poorly.
  • NPAs: grown since 2016, and the cases of IL&FS, PMC Bank, PNB and YES Bank suggest that poor management and malfeasance can overpower RBI’s inflation controlling efforts.

Conclusion

• Inflation control will always be relevant, but there is no conclusive evidence that the policy has worked in India.
• Presumed benefits of low inflation are yet to surface.
• Assuming that the decline in in?ation in India is due to in?ation targeting would stand in the way of acknowledging the source, the vagaries of the price of food.