Flexible part of inflation targeting worked well: MPC's Bhattacharya

FIT more effective than multiple indicators framework

As long as a clear and well-defined target is established, the flexible inflation framework is robust enough to guide policy decisions, while revisiting outdated approaches, such as the multiple indicators framework, would be counterproductive, said Saugata Bhattacharya, an external member of the Reserve Bank of India’s Monetary Policy Committee (MPC).

 

He said monetary frameworks, particularly those related to inflation targeting, must undergo continuous reassessment to remain effective in a dynamic economic environment. The flexibility inherent in inflation targeting has proven invaluable, especially during times of crisis.

 

“Frameworks need to be continuously reassessed, the flexible part of inflation targeting has served well, in the times of crisis. So as long as the target is established, we are okay.... we should not go back to the old multiple indicators approach in terms of monetary policy,” said Bhattacharya.

 

The RBI’s inflation target is set at 4 per cent, with a flexible band of 2 per cent on either side. After surpassing the upper tolerance band in October, headline inflation has since moderated, reaching a five-month low of 4.3 per cent in January.

 

On the current liquidity condition, Neeraj Gambhir, group executive (treasury, markets & wholesale banking) at Axis Bank, said that despite the rate cut, there has been no corresponding softening in money market rates. The anticipated transmission of the rate cut has not materialised.

 

He highlighted that if reserve money had remained unchanged, the level of reserve contraction would have essentially indicated that the RBI had substituted net foreign currency (NFC) with net domestic assets. However, this has not been the case. The RBI has not effectively sterilised the flows.

 

“The culprit for the dramatic change in the liquidity condition that we have seen is the RBI’s foreign exchange operations. If the reserve money had to remain the same, this level of reserve contraction would have basically meant that the RBI had replaced NFC with net domestic assets, which hasn’t happened. The RBI has not sterilised the flows,” said Gambhir. “The rate cut has not resulted in softening of money market rates. There has been no transmission of rate cut,” he added.

 

On the other hand, Poonam Gupta, director of NCAER, said the optimal approach to exchange rate management involves adjusting through both channels — reserves and the exchange rate — as some level of volatility is necessary for effective market functioning. Maintaining the real exchange rate within a tight range is generally not a bad strategy, she said.

 

“Right between the financial crisis and the ‘taper tantrum’, there was an effort by the RBI to not build reserves and let the exchange rate be the sole shock absorber. It resulted in reserves being stagnant in absolute terms, not even as a percentage of GDP. The exchange rate became extremely volatile, the real exchange rate appreciated, and India was affected disproportionately," said Gupta.

 

“Another situation occurred last year or so, when the sole adjustment became the reserves, and the currency was kept flat. And again, it has not been an ideal situation. An ideal mix is you are adjusting through both. Some volatility is needed.... for the most part being in the tight range of the real exchange rate is not a bad idea,” she added.