Does India’s Inflation Target Regime Need A Makeover?

We believe the framework is apt and flexible, but there is a case for some tweaks in the inflation targets.

RBI And MPC Have Delivered Well On The Target, But Is It Fortuitous?

In the period between Aug 2016 (when the inflation target was notified) and Feb 2020 (a pre-pandemic reference point given subsequent data issues), CPI inflation averaged 3.9%, a remarkable achievement. Other measures of inflation are also sub 4%. But a couple of caveats need to be considered.

First and foremost, the role of fortuitous factors needs investigating. Over the sample period, food inflation averaged a mere 2.9% and that has already proved unsustainable based on recent data. If food inflation had instead evolved in line with longer-term averages, headline inflation would have averaged 4.5%.

Importantly, core inflation averaged just a tad below 5% in the reference period, and that points to mixed internals. Second, RBI was never supposed to be a strict inflation targeter or “nutter”. So inflation alone does not capture the full picture and growth performance needs to be factored in. We assess that the output gap has been negative on average over this period, implying that some inflation success came at the cost of growth. However, blaming RBI and MPC solely for weak growth performance would be misplaced given the role of long-term and sudden administrative policy changes—such as demonetisation, GST, the Bankruptcy Code, and RERA—and a prolonged financial sector crisis that blunted monetary transmission.

Has FIT Spurred MPC To Err On The Side Of Tight Monetary Policy?

With growth and inflation metrics inconclusive, we turn to currency performance and hot money flows to assess whether monetary policy was too tight.

Although real effective exchange rates have been on the higher side and never fell below the long-period average during the sample period, it was not on account of hot money debt flows. Debt portfolio flows have been rather subdued on the whole but for a brief exception in FY18. In fact, starting FY16, India has got only around $23.5 billion of FPI debt flows in aggregate up until Feb 2020, despite adopting a liberal regime for such flows. Add the outflows witnessed in March 2020 and subsequent months, the aggregate inflow of FPI debt flows has dwindled even more (~$15 billion). FPI equity inflows have totaled ~$38 billion in the same period. Note that BoP surplus has averaged $33 bn in the FY15-20 period, same as the total surplus over the entire previous five-year (FY10-14) period. Thus the rise in REER was due to favourable starting conditions in 2015 and predates the start of FIT.

That said, basis an episodic analysis, there were clear signs of disinflationary bias in MPC’s decisions in 2017 and 2018. Interest rates were held higher relative to the headline inflation rate. Yet, these were also periods when headline inflation and core inflation diverged significantly, with the latter remaining elevated. From MPC’s behaviour we discern a revealed preference for positive real policy rates based on ex-post core inflation, and that preference only changed in 2020.

While hindsight vision is always perfect, we do believe MPC was not wrong to place bigger weights on core inflation in the operational conduct of monetary policy. We carried out formal causality tests of convergence between headline and core inflation and those reveal bidirectional causality, indicating both move closer to one another in case of divergence. However, importantly, headline inflation adjusts in a much bigger way compared to core inflation.

Taylor Rule And Financial Conditions Do Not Paint RBI As An ‘Inflation Nutter’ Either

Another approach to evaluate monetary policy stance is to compare the implied real neutral interest rate or ‘RNIR’, back-calculated from the Taylor Rule equation with a benchmark central bank like the U.S. Fed. Given India's potential growth is higher than the U.S., the RNIR should also be appropriately high.

Placing equal weights on the output gap and inflation gap (difference between core inflation and 4% target), we derive an RNIR for India at 0.7%. That compares with a 0.5% estimate for RNIR indicated by the U.S. Fed, and again confirms no large disinflation bias on part of MPC. To be sure, the RNIR for India based on headline inflation is higher, at 2.2%. But as suggested by our causality tests, we believe core inflation is a useful operational reference point for monetary policy in India, given high volatility in food inflation and lack of credible data on inflation expectations. The use of core inflation as an intermediate target however does not obviate the need for better food inflation estimates to limit forecast errors.

Finally, the post-pandemic behavior of central banks underlines the need to consider innovations in liquidity easing policies in the evaluation of stance. We believe measuring and studying financial conditions is most appropriate in this context. Based on our proprietary I-sec PD FCI gauge, we believe financial conditions were also largely neutral and not tight over the reference period. Indeed, our monetary policy index measure suggests that monetary stance has sufficiently leaned against the wind in the pre-pandemic period. Subsequently, monetary conditions have been eased similar to 2008-09 to reverse the pandemic induced tightness in financial markets.

Is There A Case To Revisit The Inflation Target Of 4% And The Inflation Target Band?

We have established that FIT has performed well in India and has not led to overly tight monetary policy, but we believe that there is a case to tinker with the numerical targets.

First, although the 4% inflation target was set in the backdrop of inflation profile in comparator economies and domestic considerations, we consider the target somewhat aspirational. It was originally set based on the inflation profile pre-global financial crisis period (Oct 2003 to June 2006) when the output gap was estimated to be near balance, and the current account balance was stable. But even in that phase, food (3.4%) and fuel inflation (2.6%) were low. Interestingly, core inflation (rebased to new CPI weights) was close to 5% at that time. If RBI and MPC are to target 4% inflation, they need significant help from non-core segments.

Else, monetary policy has to be tight to push core inflation below 5%.

The second issue relates to fixing the lower bound at 2%, which was based simply on inflation levels prevalent in developed markets. The CPI YoY inflation data for the new series starting 2014 reveals only a couple of data points that were sub-2%, and only ten data points were sub-3%.

Nearly two-thirds of the readings were clustered in the 3-6% range. Importantly, food inflation has been negative on average whenever headline inflation dipped below 3%, and that clearly shows that even the 3% lower bound for inflation can be considered low in the Indian context.

The above arguments suggest there may be a case for minor tweaks in the inflation target band. A number of different approaches could be considered. A simple change would be to peg the midpoint of the inflation target band somewhat higher, say 4.5%, and with the lower bound higher than 2%, say 3%.

A 4.5%+/-1.5% band would preserve the symmetry of the inflation target, at the cost of a narrower band and by extension some flexibility, although that is hardly a sacrifice based on the realised inflation profile. Another alternative may be to consider a band of 3%-6% without a midpoint, with the 4.5% midpoint implied as a target. But the risk in such a regime will be that MPC will come under pressure to aim closer to the upper end of the band. Notably, such pressure may not come only from the government but from the financial sector as well. The concern in both approaches is that any signal to change the inflation band that effectively pushes up target inflation might send the wrong signal.

In the above context, we look favourably upon the idea of an asymmetric band around the inflation target of 4%. That is to say a lower end of 3% and an upper end of 6% but with a 4% inflation target left unchanged. To be sure, while the emphasis on 4% may be diluted in practice with the midpoint being different and somewhat higher, the modest de-emphasis is only prudent in the face of empirical evidence. At the end of the day inflation target is a political choice by the government but grounding the change in empirical evidence and opting for evolution rather than revolution is the way to successfully sell the change to all stakeholders.

A Prasanna is Head of Research, and Abhishek Upadhyay is Senior Economist, at ICICI Securities PD.

The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.