Why sticking to RBI’s inflation targeting regime is justified

The week that went by featured several significant developments for the Indian economy.

In positive news, for the sixth month in a row, the government collected over Rs 1 lakh crore as GST. Further, data also showed that in March, India’s exports grew by almost 60%.

On the downside, the World Economic Forum’s Global Gender Gap Index ranked India at a lowly 140 out of 156 countries.

Still, the biggest news on the economic front from the last week has to be the Central government confirming that India’s central bank, the RBI, will continue to target maintaining retail inflation within the band of 2% to 6%.

On the face of it, this may sound like a non-event. After all, this “inflation targeting” regime was put in place in 2016 and has just been renewed for another five years.

But the fact is that RBI’s mandate of inflation targeting has been heavily criticised in the past — sometimes even by the voices within the government.

Why?

RBI is the main monetary policy authority for the country. In this regard, apart from being the lender of last resort as well as the regulator for the banking system, the RBI sets the benchmark for interest rates and credit growth.

Now, there are two diametrically opposite ways in which the RBI, or for that matter any central bank, can go about its business.

If the RBI sees that its main job is to boost growth in the economy then it could keep the interest rates lower while relaxing the regulations to enable quick and easy ways for the banking system to give out new loans. Cheaper loans will make it easier for firms and governments to borrow and spend/invest — thus boosting economic growth.

On the other hand, if the RBI sees that its main job is to maintain financial stability and control prices in the economy, then it would keep a tight leash on the interest rates and the norms determining the provisioning of new loans. This would, in turn, constrain economic growth.

Between 2016 and 2020, there were many times when the RBI’s single-minded focus on keeping retail inflation within the 4% +/- 2% band was blamed for interest rates being too high for businesses, and thus hurting India’s economic growth.

The odd thing with inflation targeting is that it can justifiably be questioned on several counts.

To begin with, one could argue that instead of headline retail inflation, the RBI should focus on the retail core inflation rate, which is the inflation rate without taking into account the fluctuations in the prices of fuel and food items.

Since fuel and food prices often shoot up in the short-term due to temporary factors — say, excessive rains or some other supply disruption — it is best for the RBI to focus on core inflation. The logic being that it is the core inflation that is the most robust indicator of the rate of rise in prices.

Others can argue that the RBI should not be looking at retail inflation at all. Instead, it should look at wholesale inflation.

Why?

Because RBI’s move to tweak interest rate affects the credit available to businesses, which, in turn, are affected by wholesale inflation, and not retail inflation. It can be argued that if retail prices of fruits and vegetables spike due to unseasonal rains, thus pushing up retail inflation, then raising interest rates — an action that would make it costlier for all manufacturing and services firms to get a loan — will not help matters anyway.

Proponents of this view pointed to the vast gap between the retail and wholesale inflation rates in recent years.

Still others say that ideally, the RBI should neither use the wholesale nor retail inflation rate as targets. Instead, it should create a Producer Price Index — a more focussed inflation rate index to best suit RBI’s need.

The questioning of inflation-targeting was not limited to what type of inflation rate should be targeted but also included the extent of this targeting.

Why should RBI maintain inflation at 4%? Why not 5%? Why should the range be between 2% and 6%? Why not wider or narrower?

As you would understand, each such decision would tweak the degrees of freedom the RBI has in terms of setting the credit policy in the economy.

But, of course, the opposition to inflation targeting regime was also from those who argued that the whole idea was inadvisable. For many, such a singular focus on maintaining price stability is a counter-productive choice for a developing economy such as India.

They argue that instead of being overly finicky about the inflation rate — be it wholesale or retail —the RBI should be working with the government towards ensuring fast economic growth. If that means reducing interest rates and relaxing lending norms so that borrowers (companies as well as governments) can borrow at easy terms then the RBI should play ball. By applying onerous prudential norms that are used in the West and prioritising price control, the RBI is hurting India’s growth potential, or so goes the argument.

What fuelled many such reservations and criticisms was India’s decelerating economic growth rate since the start of 2017. It also mattered that in the past RBI never had an explicit mandate to target a particular level of inflation. Even so, India did avoid being as severely impacted by several global financial crises in the past. So the argument was: Inflation targeting is not the only way to be prudent about macro-financial stability.

Given this long list of complaints, it was a significant event that RBI’s mandate has not been changed at this crucial juncture.
Already, since the time current RBI Governor Shaktikanta Das took charge, there has been a clear shift in the RBI’s stance towards doing everything in its power to boost economic growth. This phase has largely coincided with the economic disruption due to the Covid-19 pandemic. Over the past 12 months, the RBI has either relaxed or suspended several regulatory norms to soften the blow of economic distress.

But this is also a phase where the inflation rate has consistently stayed above RBI’s comfort zone. It is important to point out that a high inflation rate is the most regressive kind of tax — the poorest are hit the hardest.

As India starts a new financial year, there is a tremendous and understandable urgency to grow fast and get back to the days of high GDP growth rate.

But it is also true that in the months and year ahead, as banks start recognising bad loans or non-performing assets on their books, macro-financial stability will come into sharp focus. Moreover, with fuel prices staying high and another wave of Covid-induced lockdowns likely, supply bottlenecks could lead to inflation rates spiking again.

Under the circumstances, it is a wise decision by the government to not ask the RBI to give up targeting retail inflation. This non-event will likely ensure that India’s poorest, who are already hit by the pandemic, do not get further penalised.

This week, the RBI will act on this freshly renewed mandate as its Monetary Policy Committee (MPC) announces its bi-monthly credit policy review. It is widely expected that, given the concerns about inflation, the MPC will avoid tweaking the benchmark interest rates.

Lastly, another noteworthy development this week would be the release of International Monetary Fund’s World Economic Outlook late Monday evening.