Tweaking the inflation targeting mandate

A key focus for the new govt should be to ensure wider consultation in setting inflation target

World over, doubts are being raised about the effectiveness and even relevance of the inflation targeting mandate of central banks.  Central banks have faced criticism for failing to correctly judge and predict the interest rate-inflation dynamics during the post-Covid period.

Take the Indian case. The Reserve Bank of India (RBI) kept the interest rates quite low during 2020-21 and 2021-22.  Inflation had conspicuously started raising its head by the middle of 2021-22, but was considered transitory by the central bank and ignored. Then, all of a sudden, in May 2022, the RBI began one of the steepest interest rate-raising cycles in recent history. The repo rate was increased from 4 per cent to 6.5 per cent by February 2023, and rates have been kept at this level since then.    

For quite some time now, the markets have been speculating about when the RBI would start reducing interest rates. Many experts view the current real interest rates to be high, discouraging new investments and hurting growth.  The arguments circulating suggest that the increase in repo rate has achieved its purpose, and it is time for the RBI to announce a road map for rate cuts. Some advocate that the real interest rates shouldn’t be more than 1-1.5 per cent, and question whether consumer price index (CPI) is the right inflation index to target. They argue that the RBI should take the lead in reducing rates without waiting for the US Fed to do so. On the contrary, there are others who support keeping the rates high to bring the CPI below 4 per cent. Some have even raised the basic doubt of whether the central bank can actually credibly control inflation.

This column examines the need for tweaking the present inflation-targeting mechanism in India, an issue that should be prioritised by the new government formed in June.

But before that, a few words on the current stand taken by the RBI on inflation. The RBI is right in focusing on bringing the CPI-based inflation below 4 per cent. The RBI Act, as amended in 2016, mandates the RBI to keep CPI within 4+/-2 per cent. The RBI lacks discretion to target some other inflation index. In fact, had the RBI adhered strictly to its mandate in 2021-22, the current situation of high real interest rates might have been averted. Even from a growth perspective, there are no compelling reasons for the RBI to cut rates; gross domestic product (GDP) is projected to grow by 7.6 per cent in FY24 and more than 7 per cent in FY25. As for ignoring the US Fed actions, there are limitations, given the dollar’s hegemony in international trade and finance.

When it comes to the inflation targeting mechanism, to begin with, an ab initio look at what is being targeted would be helpful. What are the commonly used different inflation measuring indices and the purposes they serve? What is the interplay amongst these indices — are they often projecting a conflicting inflation picture? There is a need to revisit the constituents of these indices as well as their weights.

The CPI, WPI and GDP deflator are the three indices commonly used by economists in various analyses. While they surely serve different purposes, of late, the lack of correlation in their movements has raised many eyebrows. Enough commentary is available in the public domain, debating the usefulness of these indices, besides doubting their computation methodologies. The unusually low GDP deflator during 2023-24, which pushed up the GDP figures, has been a topic of discussion amongst experts. Some have argued that the GDP deflator should be taken into account by the RBI while targeting inflation.

Without going into technicalities, common sense dictates that the target inflation index for the central bank, regardless of what it is called, should be so constructed that it accurately reflects changes in consumer prices of goods and services commonly used by the general public. High prices impact the poor the most, and the aim should be to contain the type of inflation that brings hardship to them. The index’s constituents should be periodically revised after conducting a credible survey, and in consultation with stakeholders.

 Now, let’s turn to the existing inflation target of 4+/-2 per cent. This was fixed by the government, in consultation with the RBI, in 2016 for a period of five years, and later re-adopted for another five years in 2021. What is the basis for selecting this target, including the wide band of +/-2 per cent? Considering the inflation rate-economic growth dynamics, knowing what inflation rate to target is crucial for the growth of any economy. Should achieving near-full employment or minimising the output gap in the economy be the objective, while deciding the optimal target inflation rate?  The government should take a fresh look into the matter and have wider consultations while finalising the inflation target. The broad contours of the rationale, the assumptions made, and the computation methodology ought to be in the public domain.

One of the arguments put forth by the RBI for not being able to meet the inflation target during 2021-22 was that the monetary policy wasn’t the right tool to contain the inflation then, which was primarily on account of supply-side disruptions. There is some merit in this argument. But then, what is the way forward in such a situation? Can the RBI be completely let off the hook?

That brings us to the issue of RBI’s accountability under the law, and ensuring transparency. Section 45ZN of the RBI Act, 1934, mandates the RBI to submit a report to the government if it fails to contain average inflation below 6 per cent during the previous three quarters. The report should contain the reasons for failure to achieve the inflation target; proposed remedial actions to be taken by the Bank; and an estimate of the time-period within which the inflation target  shall be achieved following timely implementation of proposed remedial actions.

The RBI did submit such a report to the government in November 2022. What does that report say and what action has been taken by the government on that report? Considering the hullabaloo about inflation, and the fact that the genesis of inflation getting out of control lies in the second half of 2021-22, it would be fair for the government to publicly disclose, in an appropriate manner, the gist of the report and the action taken thereafter. 

The writer, formerly in the Indian Administrative Service and chairman of  Sebi, is a distinguished fellow at the Observer Research Foundation