The Myth Of India’s ‘Flexible’ Inflation Target
It turns out that the RBI does not see much flexibility in the inflation target handed to it, writes Ira Dugal.
When, on Dec.5 2019, India’s monetary policy committee decided to keep interest rates unchanged, a question was raised—including by this writer—about the panel’s decision to ignore the ‘flexible’ in its flexible inflation targeting mandate.
The economy had just seen GDP growth fall to a six-year low of 4.5 percent and, by all accounts, demand conditions were weak. Simultaneously, inflation had risen but mostly due to a spike in vegetable prices. The central bank raised its inflation forecast for the current year but projected one-year ahead inflation, in the first half of FY21, at 4-3.8 percent, within the 4 (+/-2) percent inflation target band. It cut its GDP growth forecast for the current year to 5 percent and pegged growth in the first half of next year at 5.9-6.3 percent, below the 6.5-7 percent considered as potential output.
Yet, the MPC voted for a pause in rate cuts. If the central bank saw the inflation spike as temporary and growth as weak, why didn’t it chose to use the flexibility provided by its inflation target of 4 (+/- 2) percent?
It turns out that the central bank does not see much flexibility in the inflation target handed to it. The reason is that the notification issued by the central government in June 2016 virtually pegs 4 percent as a fixed target rather than a flexible one, while 2 percent and 6 percent are defined as the lower and upper “tolerance levels”.
The June 27, 2016, notification in the Gazette of India reads as below:
In exercise of the powers conferred by section 45ZA of the Reserve Bank of India Act 1934, the Central Government, in consultation with the Bank, hereby notifies the inflation target for the period beginning from the date of publication of this notification and ending on March 31, 2021 as under:
- Inflation Target: 4 percent
- Upper Tolerance Level: 6 percent
- Lower Tolerance Level: 4 percent
Central bank insiders say the wording of the notification leaves them with far lesser flexibility than analysts and investors believe.
Test Of Short-Term Growth-Inflation Trade-Off
The interpretation of the flexibility, or lack of it, is important as the Indian economy prepares to face a period in which there may be a short-term trade-off between policy choices needed to spur growth and those required to keep inflation close to the target.
Following the MPC’s December decision, Governor Shaktikanta Das said that the pause in rate cuts is “temporary”. The minutes of the December monetary policy committee meeting show that most panel members chose to be adopt a ‘wait and watch’ approach to see how inflation plays out.
MPC member Chetan Ghate pointed to the sharp rise in inflation expectations – the steepest in three years. Ravindra Dholakia noted that higher inflation is not just confined to a few items. It is important to understand how much would be the impact and for how long, he said. RBI executive director Michael Patra said that any spill-overs from the higher food prices need to be watched. Governor Das, too, said that there is need for greater clarity as to how the overall food inflation path is going to evolve.
Should some of these concerns materialise, the MPC may not find any room to lower interest rates further, even if the output gap—defined as the difference between and actual and potential growth—remains wide.
Most forecasters expect that growth will remain weak in 2020-21 and see further rate cuts. Those rate cuts, however, may only materialise if headline consumer price inflation shows signs of moving to or below 4 percent decisively.
4 Percent Inflation Target: Is There Need To Revisit?
The longer term debate raised by the current blend of economic conditions—where inflation and real GDP growth have been low leading to an unprecedented decline in nominal GDP growth—is whether India picked the right inflation target and the right level of inflation to target.
The target comes up for review in 2021 and ahead of that a review is likely to be undertaken by the government, with inputs from the central bank. The central bank, however, may not see much reason to suggest a change in the nominal anchor or the chosen target.
The 4 percent target was picked because it was seen as the neutral level of inflation, beyond which any positive impact of low inflation on growth starts to wane. When inflation moves beyond 6 percent, its effects on growth start turning negative, various studies by the central bank over the years have shown. Targeting headline inflation rather than core inflation also remains a preference as food price spikes tend to impact inflation expectations and leads to generalised inflation fairly quickly in India.
The eventual decision rests with the government but should that thinking prevail, monetary policy in India will continue to have limited flexibility in supporting short term growth concerns at times when inflation moves above the 4 percent target, despite the wider tolerance band seemingly provided as part of India’s ‘flexible’ inflation targeting regime.
Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.