Does inflation target band work? Yes, but some want core also monitored

A recent RBI report also suggested that the current 2-6 per cent band was appropriate and should continue for the next five years

As the Centre and Reserve Bank of India (RBI) prepare to review the retail price inflation framework this month, economists have batted for the continuation of the current target of four per cent with a tolerance limit of plus or minus two per cent, but added that core inflation should also be monitored.

The target is valid till March 31, according to the RBI Act, amended through the Finance Act, 2016, which also brought in the six-member monetary policy committee (MPC).

However, some economists, such as Madan Sabnavis of CARE Ratings, feel the target should be raised to five per cent, plus or minus two per cent, adding that it is clearly mentioned in the law that economic growth should also be a part of the target.

The consumer price index-based inflation rate remained above the upper target of six per cent for most of 2020, but the MPC followed an accommodative policy, at least in the initial part of the lockdown, to prop up dwindling growth. This gave rise to calls for altering the current framework to allow for pro-growth policies.

Former chief statistician Pronab Sen said he didn’t want headline inflation to be the only target in a country like India. “I would prefer the second target, which would be the core,” he said. Core inflation relates to all items, except food and fuel, as the two are volatile.

Sen, who is now India programme director for the International Growth Centre (IGC), said core inflation should be targeted at three per cent plus or minus one per cent.

Explaining his focus on core inflation, Sen said: “When you have a monsoon failure, taking decisions on the basis of headline inflation would be wrong, because monsoon failure is a contractionary event. If on top of that you add further contractionary interest rates, you are becoming pro-cyclical, while you need counter-cyclical policies at such times.”

If food prices are rising because income distribution has improved, then you need to temper that down, Sen said. “So, you have to choose which target to follow at any given time. It should be left to the MPC to decide rather than being tied down in law,” he suggested.

Devendra Pant, chief economist of India Ratings, said though inflation targeting has worked the key is forecast. “We should understand that policies aren’t based on one month’s inflation print, they are based on how inflation will go out in the medium-term. Whether the movement is due to base effect, or cyclical factors or it has become structural are important factors,” he said.

Higher inflation because of high food prices sets in higher wage expectations, which may lead to higher inflation as a second-round effect, he said. “This is the reason for headline inflation being used instead of core inflation. The 2-6 per cent range is most likely to be retained,” Pant said.

Aditi Nayar, principal economist of ICRA, said, “In our view, the upper end of the inflation target band should be retained at six per cent to avoid unanchoring of inflation expectations.”

Shubhada Rao, founder of Quanteco Research, said the current framework has worked well to anchor inflation and expectations. “It is imperative that the inflation band be retained to not just anchor inflation expectations but for macroeconomic stability,” she said.

Earlier, Principal Economic Advisor Sanjeev Sanyal had told Business Standard that the inflation target has worked reasonably well. He said the target range of 2-6 per cent does not require any major tinkering.

Recently, RBI released the Report on Currency and Finance 2020-21, which suggested that the current inflation target band was appropriate and should continue for the next five years. The RBI moved to an inflationtargeting framework in 2016, and the MPC has met 22 times since then.

The target has served the country well in anchoring inflation, argued the report. The current law states that in case the inflation target is breached, RBI has to send the government a report stating the reasons for failing to achieve the target and proposing remedial action.

CPI inflation remained over six per cent for the first three quarters of 2020 and in October and November as well. However, RBI escaped government scrutiny because CPI for April and May was imputed. Imputation is the substitution of prices of some groups for those of similar segments (and assorted accordingly) for which information is not available. This was necessitated by the lockdown.