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India's Inflation Targeting Plan Increases Policy Transparency and Predictability

Capital Market 

Shirin Mohammadi, Associate Analyst and Atsi Sheth, Senior Vice President, Sovereign Risk Group, Investors Service Singapore

On Monday, the Reserve (RBI), the country's central bank, made public an agreement with the Ministry of Finance that mandates the RBI to bring below 6% by January 2016, and 4% (plus or minus 2%) in the following years. This flexible targeting framework is credit positive for (Baa3 stable) because it increases monetary policy transparency, predictability and chances of effectiveness.

In the past decade, India's was higher and more volatile than in several comparable economies. Persistent inflation lowers international competitiveness, erodes consumer purchasing power and raises the domestic cost of capital.

Quantitative inflation targeting will foster transparency and predictability in monetary policy, as capital market participants, businesses and the public understand the drivers of central bank actions. In addition, the forward-looking nature of inflation targeting will encourage a focus on future, rather than past, price trends. All of this will anchor inflationary expectations and increase the effectiveness of monetary policy tools in achieving their desired results. An increase in monetary policy transparency and effectiveness will likely lessen volatility in international capital flows into Additionally, inflation targeting will support institutional strengthening via accountability.

Food and global commodity prices are key drivers of inflation in India and they are generally immune to the effects of monetary policy. This raises the question of whether the central bank's focus on lowering inflation through higher interest rates will hurt economic growth without addressing the causes of inflation. In our view that is unlikely, because unchecked inflation has a greater chance of hurting growth than monetary policies to curb inflation. This was evident between 2011 and 2014, when inflation, largely driven by food and commodity prices, ultimately compromised growth. Moreover, as the RBI implements its mandate to curb inflation regardless of its source, the government may heighten efforts to lower food inflation by reducing inefficiencies in food production, distribution and administered pricing.

The mandates of India's fiscal responsibility framework were eschewed in the period following the global financial crisis, raising questions about the durability of the new monetary framework. We expect the framework to endure because the institutional structure and drivers of monetary policy are different than government fiscal policy, which incorporates social and political considerations. Moreover, India's macroeconomic history has fortified a consensus that curbing inflation should be a policy priority.

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First Published: Thu, March 05 2015. 10:56 IST