Case for Tweaking Inflation Targeting

Monetary policy is governed by the central bank of the country, that is, Reserve Bank of India in case of India. Monetary policy deals with quantitative and selective measures of credit control, which include policy rate of interest, open market operations, cash reserve ratio and others. All over the world rate of interest is an important instrument in monetary policy operations. Reserve Bank of India announces the policy rates of interest, depending upon their perception about inflation and the demand and supply of credit in the economy. Before 2017, Reserve Bank of India was using Wholesale Price Index (WPI) to determine their perception about the stance for future inflation. On that basis, RBI used to announce policy rates of interests. However, in 2014, when Raghu Ram Rajan was the Governor, RBI, under the chairmanship of the then RBI Deputy Governor Urjit Patel, a committee recommended to use Consumer Price Index (CPI) rather than WPI for inflation targeting. Since that change the decisions of RBI about inflation targeting has been impacted, as there was a huge difference between CPI and WPI.

On 27th June 2016 the Monetary Policy Committee (MPC) first came into existence. The Monetary Policy Committee consists of 6 members, out of which three members are the officers of Reserve Bank of India and three are external members nominated by the Government of India. The Governor of the Reserve Bank of India is the Chairperson ex officio of the committee. MPC announces the monetary policy for the country. Decisions are taken by majority with the Governor having the casting vote in case of a tie. The current mandate of the committee is to maintain 4% annual inflation until 31 March 2026 with an upper tolerance of 6% and a lower tolerance of 2%. In the past few years there has been a huge difference between CPI and WPI, while CPI remaining too high as compared to WPI. In the last financial year, though CPI continued to be high,WPI came in negative zone. But based on the mandate for MPC, that they will use CPI for their inflation targeting and therefore, determination of policy rates of interest, MPC has been keeping the repo rate at the same high level of 6.5 percent, since January 2023, despite a much lower WPI. It is no secret that policy rates of interest, especially repo rate is very crucial for growth in the economy. We understand that low rate of interest encourages investment and purchase of consumer durables and houses. If rate of interests keeps high, those with surplus funds will try to hold interest bearing bonds and not invest the same. Also, those who need to borrow for investment and purchase of consumer durable and houses, would be less inclined to do so. In this context it become important that what we consider as inflation and inflation targeting. 

Many economists have now started questioning the CPI based inflation targeting, as it is becoming evident that there is a need to tweak, what we are targeting at monetary policy. Though, there is near unanimity that monetary policy needs to target low inflation rate, to make sure that masses do not reel under inflation, as it hits poor the most. However, questions are been raised about sanctity of using CPI as the basis of inflation targeting. Those who say so, base their case on the following arguments:- First, and foremost point they make is, that the idea of inflation targeting is an imported idea from the west. We understand that the objectives of monetary policy in a developing country like India, include growth, employment and uplifting of poor and downtrodden. No monetary policy is complete without addressing these objectives. Secondly, we have to see whether WPI or a blend of CPI and WPI or some other indices should be used for inflation targeting. Though, in the post MPC and CPI anchoring era, when CPI inflation rate was low, and therefore, rate of interest has been generally gradually declining, growth obviously did not get hamper. However, in the post Covid period due to reasons not related to fundamentals of Indian economy, CPI was keeping high (primarily due to disruption in global value chains, soaring food prices due to global shortage of food and increase in fuel prices), which led MPC to raise policy rates of interest. However, we see that during this period between 2021-22 and 2023-24, the WPI was keeping much lower than the CPI, and ultimately entered into negative zone. However, since MPC was using CPI as anchor for inflation targeting, higher interest rates, started impacting growth by causing WPI travelling in negative zone. This caused a situation of deflation in the country. This situation is not very auspicious for the economy. Therefore, it is the time to pause and think about tweaking the anchor for inflation targeting. Must remember, economic policies, whether fiscal or monetary, cannot move in straight line fashion. We must realise the complexities of the real world before deciding on economic policies.

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