Inflation targeting is a monetary policy framework in which a country's central bank focuses solely on keeping inflation within a certain range. Increasing prices in an economy are thought to cause uncertainty in decision-making, reducing savings and boosting speculative investments (such as buying Gold). In India, the Reserve Bank of India (RBI) has signed a Flexible Inflation Targeting Framework (FITF) with the central government to keep inflation in a range of 2-6%. Inflation targeting is an important topic for the UPSC exam where questions are frequently asked.

What is Inflation Targeting?

• Inflation Targeting is a central banking policy that focuses on altering monetary policy to attain a set annual inflation rate.
• Inflation targeting is founded on the assumption that preserving price stability, which is achieved by managing inflation, is the greatest way to generate long-term economic growth.
• New Zealand was the first country to embrace inflation targeting, and since then, a large number of nations, including India, have chosen it as their primary monetary policy tool.

Inflation Targeting: Indian Scenario

• In India, the Monetary Policy Framework Agreement agreed between the RBI and the government in 2015 established inflation targeting.
• According to the provisions of the agreement, RBI's principal goal will be to preserve price stability while also pursuing growth.
• The RBI is mandated to maintain a rate of inflation of 4% with a 2-percentage-point deviation, i.e. inflation must be kept between 2% and 6%.
• If consumer inflation is more than 6% or less than 2% for three consecutive quarters beginning in the 2015/16 fiscal year, the central bank will be considered to have missed its objective.

If the central bank fails to meet its inflation target then:

• It will send a report to the government explaining why and what steps it will take to correct the problem.
• It will also have to provide an estimate of how long it will take to return to the target level.

Inflation Targeting: Benefits

Enhanced Transparency:

• Inflation targeting specifies the rate of inflation that should be targeted in a given economy. With such publicly legislated aims, there is better clarity and predictability in terms of the inflation rate and monetary policy formulation.

Promote Growth:

• A high rate of inflation diminishes the buying power of the currency, lowers the rate of savings and investment, raises unemployment, and lowers the overall rate of GDP growth. Furthermore, a high rate of inflation is accompanied by larger levels of Fiscal and Current Account Deficits, putting the country's macroeconomic stability at risk. As a result, a low or moderate amount of inflation would encourage investors to invest in the economy, promoting higher growth and development.

RBI's Autonomy and Accountability:

• The RBI has been given entire autonomy in managing the rate of inflation within the prescribed targets under the Monetary Policy Framework Agreement. If the RBI fails to keep inflation within the target range, it would be compelled to explain why in writing. Such a clause allows the RBI to have autonomy while also allowing the government to have greater accountability over the RBI's actions.

Empirical Evidence:

• Inflation targeting has shown to be quite successful in certain advanced economies, such as the United Kingdom and New Zealand. These advanced economies have been able to keep inflation at a reasonable level for a longer period of time, resulting in enhanced macroeconomic stability.

Inflation Targeting: Challenges and drawbacks

Disregards the RBI's multifaceted role:

• It is impractical for a central bank in a developing country like India to focus just on inflation without considering the greater development context. The Reserve Bank of India (RBI) must strike a balance between growth, price stability, and financial stability.

There is no clear link between price and financial stability:

• Prior to the 2008 Global Financial Crisis, advanced economies were able to sustain a low rate of inflation for an extended period of time, owing to the use of Inflation Targeting. Inflation targeting was thought to be responsible for the country's overall macroeconomic stability.
• However, the 2008 Global Financial Crisis demonstrated that price stability alone does not guarantee financial stability and that a central bank's excessive reliance on price stability may lead to the neglect of other critical functions such as regulation, resulting in an economic crisis.
• Former RBI Governor Subbarao has stated that there is a trade-off between pricing stability and financial stability and that the more successful a central bank is at maintaining price stability, the more likely it is to jeopardize financial stability.

Inflation Targeting in India:

• Empirical Evidence Since the previous 2-3 years, the RBI has been able to keep inflation within the statutory range. Despite a constant rate of inflation, the Indian economy is confronted with numerous obstacles. For the first quarter of the fiscal year 2019-20, the GDP growth rate has been lowered to a 25-quarter low of 5%.

Unemployment Rate:

• The jobless rate has risen to 6.1 percent, a 45-year high. Manufacturing activity has decreased, as seen by the decline in IIP. The agrarian crisis is threatening the agriculture industry. All of this demonstrates that inflation targeting has failed to foster economic growth and development.

Transmission of Monetary Policy Is Inadequate:

• Inflation targeting is better suited to mature economies since monetary policy transmission is more efficient in these countries. However, in India, the transmission of monetary policy is inefficient, which can impair the efficiency of inflation targeting.

Low GDP growth:

• In order to keep inflation under control, the RBI would have to raise interest rates by implementing a contractionary monetary policy. However, such a strategy would result in a rise in the rate of interest on loans, lowering investment and consumption expenditure and lowering GDP growth rates.
• During the period 2013-2015, for example, higher interest rates in the country due to higher inflation rates resulted in lower GDP growth rates.

Does not address Supply-Side Inflation:

• Inflation in India may occur as a result of supply-side bottlenecks such as rising global crude oil prices, poor monsoon conditions, and floods, among other things.
• The current surge in tomato and onion prices, for example, is primarily due to supply-side interruptions. In such conditions, the RBI's influence in lowering inflation rates would be limited.
• Rather, the Indian government would be forced to handle these supply-side disturbances in order to keep commodity prices in check.

Conclusion

Inflation targeting will ensure that there is transparency in the central bank's role and the targets for inflation in the economy. However, over a long period of time, it hinders the true potential of growth in the economy as it throttles the growth to achieve price stabilization. In extraordinary circumstances such as the COVID pandemic, inflation targeting is not a solution, and caveats for the same can be incorporated into the inflation-targeting frameworks.