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An Objective Analysis on the efficacy of Monetary Policy in India

An Objective Analysis

Inflation Targeting (IT) is like the guiding compass for our central banking strategy. It’s all about tweaking our monetary policies to hit a specific yearly inflation rate. The big idea behind this is that if we keep prices stable, we’ll pave the way for long-term economic growth. The Urjit Patel Committee vouches for this approach. Finance Bill of 2016, an amendment to the RBI Act has made IT the RBI’s primary mission. And you bet, they’re answerable if things don’t go as planned.

The government has set the target at 4 percent for Consumer Price Index (CPI) inflation from August 5, 2016, to March 31, 2021. There’s some wiggle room, though, with 6 percent as the upper limit and 2 percent as the lower one. In a recent report on Currency and Finance for FY21, the Reserve Bank of India gave a thumbs-up to the current inflation target of 4%, with a leeway of +/-2%. They think it’s the right call for the next five years.

Important Observations Made

  • Before flexible-inflation targeting (FIT), trend inflation was high, exceeding 9%. However, during FIT, it has stabilized within the range of 3.8-4.3%, suggesting that 4% is considered an appropriate level for the inflation target.
  • To maintain economic stability, an upper limit of 6% is deemed acceptable for the inflation target. This means that policymakers aim to keep inflation below this threshold to prevent adverse economic effects.
  • Setting a lower bound above 2% is crucial, as going lower may result in actual inflation frequently falling below the acceptable range. On the other hand, if the lower bound drops below 2%, it can hinder economic growth. Therefore, an inflation rate of 2% is considered an appropriate lower tolerance bound.

Concerns over efficacy in inflation targeting

Unseen Economic Model: The economic model supporting inflation targeting remains largely hidden from public discourse. It asserts that inflation indicates economic overheating, caused by central banks maintaining interest rates lower than the supposed “natural” levels, leading to a recommendation of raising interest rates to curb inflation.

Logical Vulnerability: The theory’s core concept, the “natural level of output,” is unobservable, making it nearly impossible to validate. This creates a logical vulnerability as the explanation becomes self-referential.

Mirage of Success: Inflation targeting is deemed successful as inflation has stayed within the agreed-upon band. However, inflation in India entered the prescribed band two years before the adoption of inflation targeting, and the steady decline in inflation since 2011-12 suggests alternative factors at play.

Food Price Impact: The decline in inflation over five years was primarily influenced by falling food prices. This challenges the notion that inflation targeting was solely responsible for anchoring inflation expectations, especially when considering the sharp decline after the COVID-19 lockdown in March 2020, indicating factors beyond overheating.

Conflicting Patterns: Analyzing the impact of inflation targeting over the past five years on key variables:

  • Growth: The economy’s trend rate of growth declined after 2010-11, and falling inflation did not revive growth as expected.
  • Investment: Higher interest rates, a tool for inflation targeting, might have been detrimental to private investment.
  • Exports and Employment: Both showed poor performance since the official adoption of inflation targeting.
  • Non-Performing Assets (NPAs): NPAs have grown since 2016, raising concerns about the central bank’s focus on inflation over financial stability, as evident in cases like IL&FS, PMC Bank, PNB, and YES Bank.

      Read Also: Inflation Explained

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