Question:- 46. Explain the inflation targeting mechanism of RBI. Discuss the problems associated with this method of adjusting monetary policy. Answer in 150 words.
Aug 23, 2022
Inflation Targeting is a method that focuses on adjusting monetary policy to achieve a specified annual rate of inflation. The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation. The amended RBI Act provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once every five years.
Every two months, the Reserve Bank’s MPC has a review meeting where they discuss the likely inflation and growth estimates over the coming months. Based on this review, the MPC targets inflation using the policy rate, or the repo rate. When inflation is higher than the inflation target set by the central bank, then the MPC must increase the repo rate. On the other hand, when the actual inflation is lower than the target, the MPC could decrease the repo rate. The MPC looks at consumer price inflation (CPI) as the inflation target that it must keep between 2% and 6%.
The framework agreement requires the RBI to submit a report to the Union government if it is in breach of the inflation targets for three consecutive quarters.
1.There is high sensitivity of India’s inflation index, especially the CPI to changes in fuel and food prices, both of which are not affected by the rates of interest. Critics have argued for the need to look at an indicator of inflation that excludes food and fuel, or at measures of inflation, instead of just the CPI. Others point to the role played by consumer expectations regarding future inflation, which depends on the prices that they witness in the market.
2.Assumption of correct output level: The model of Inflation targeting is based on the assumption that inflation means overheating the economy (i.e. output or production is greater than natural level output/production.)However, it is impossible to observe the level of output in an economy. Hence, setting policy rates based on the assumption that the economy is overheated, is unscientific.
3.Limited power of RBI: The belief that RBI can successfully control inflation using Inflation targeting is not completely true. During the lockdown, food inflation peaked even when the inflationary targeting mechanism was in force. It was mainly due to supply chain disruption during the lockdown.
4.Adverse impact on other sectors: The cases of IL&FS, PMC Bank, PNB and YES Bank suggest that poor management and maladministration in the financial sector can escape RBI scrutiny as they tend to focus more on inflation targeting.
5. RBI has kept the interest rates high to manage inflation. This has discouraged private investment thereby reducing employment and export potential.
6.Global Nature of inflation: Inflation is global in nature as the price level of a good is determined by millions of producers across the world. Research by economic experts has also pointed out the international influence on the inflation level. E.g. Russia-Ukraine war
Inflation targeting gives an indication to potential investors about future. It also builds confidence in the broader economy that is still prone to both supply shocks and sudden demand shrinkage. Nonetheless, some reforms are desired in the Inflation targeting procedure to achieve optimum outcomes.