Economists welcome decision, but argue for a higher upper limit
The Centre, on Wednesday, kept the inflation target of the monetary policy framework unchanged at 2-6 per cent for the next five years, until the fiscal year 2025-26.
The 4 per cent anchor point target for inflation — with an upper tolerance limit of 6 per cent and a lower limit of 2 per cent, measured in terms of consumer price index (CPI)-based inflation — was set by the government in consultation with the Reserve Bank of India (RBI) in 2016 and its validity expired on Wednesday.
“We decided to keep the inflation target as it is for the next five years,”’ said Economic Affairs Secretary Tarun Bajaj. However, core inflation has not been added to the mandate.
Economists welcomed the government’s decision. “The decision to maintain the flexible inflation targeting framework in its entirety is good news as it will help provide stability and allow the monetary policy committee (MPC) to continue in its endeavor of pushing inflation expectations down toward the 4 per cent headline CPI target in the years ahead,” said Kaushik Das, India chief economist, Deutsche Bank.
“While core inflation has not been added as a separate variable within the inflation-targeting framework, we think that in reality, MPC members will put a lot of emphasis on the evolving core inflation trend (as they have been doing in the past, as well) to inform their monetary policy decisions in the future,” Das said.
Madan Sabnavis, chief economist of CARE Ratings, also lauded the decision but said a higher tolerance was preferable. “A higher upper band could have been considered as future inflation would be greater than 5 per cent once the economy is in the expected growth phase. This can cause asymmetry in the MPC’s reaction to inflation, especially if it crosses 6 per cent often. Can we raise interest rates then?” Sabnavis said.
The CPI rose to 5 per cent in February, from 4.1 per cent in January, because of increased food and fuel prices, which jumped 3.87 per cent and 3.53 per cent, respectively.
With the 2-6 per cent inflation mandate in place, the six-member MPC, headed by the RBI governor, met 22 times. The MPC is again scheduled to meet in the first week of April with an unchanged mandate.
According to the mandate, if the RBI fails to keep inflation within 2-6 per cent for three consecutive quarters, it has to write to the government to justify the reasons for it. However, 2020 was taken as an exception because of the pandemic and extra accommodations needed to tide over it. Inflation remained above the target range for most of it.
It was widely expected that the inflation target would remain unchanged with central bank officials arguing in favour of it, both directly and indirectly.
The central bank recently published its report on currency and finance, for the first time since 2013, to argue that the inflation target had served the country well, and should be preserved.
The report argued that since advanced economies keep their inflation target unchanged at 2 per cent, notwithstanding persistent deflationary conditions, the lower tolerance band in India should not be less than 2 per cent.
On the upper tolerance limit, “international experience suggests that countries with a large share of food in the CPI basket tend to have higher inflation targets and wider tolerance bands. Threshold estimates over a longer sample period work out to 6 per cent, beyond which tolerance of inflation can be harmful to growth”.
Therefore, the current tolerance band of /-2 per cent should be retained, “notwithstanding the central tendency emerging from the country’s experience of lowering targets and narrowing bands over time,” it had said.
Even as the report was not an “official” RBI view, the foreword was written by the RBI governor himself and the RBI’s preference was abundantly clear. “A target set below the trend imparts a deflationary bias to monetary policy because it will go into overkill relative to what the economy can intrinsically bear in order to achieve the target,” argued a paper authored by RBI Deputy Governor Michael Patra, along with Harendra Kumar Behera, in December 2020.
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