It isn’t broken. Don’t fix it

Last Updated25/09/2024

The question of whether India should modify or abandon its Inflation Targeting (IT) framework has gained prominence recently, especially ahead of the mandated review of the monetary policy framework.
While periodic assessments of policy effectiveness are vital, it is crucial to recognize that the IT framework has emerged as one of the most significant reforms in India's monetary policy in the last decade, delivering stability and credibility.
A retreat from this framework could undermine the Reserve Bank of India (RBI)'s credibility, harm the economy, and generate political backlash.

The IT framework was introduced in response to rampant inflation during the UPA government from 2009 to 2012, when inflation surged to 15%. The lack of accountability in the RBI's previous “multiple objectives” approach led to public outcry and a change in government.
To ensure commitment to price stability, the new government enshrined IT into law, with a target of 4% inflation and a permissible band of ±2%.

Since its implementation, the IT framework has largely succeeded, with the RBI managing to keep inflation within the established band.
Even amidst significant external shocks like fluctuating oil prices and the COVID-19 pandemic, inflation has not returned to double-digit levels, providing a stable environment for businesses and contributing to economic growth.

Price stability has allowed businesses to plan effectively, fostering a conducive environment for investment and economic growth. Lower inflation has also improved the RBI's credibility, reducing the need for higher interest rates, which benefits consumers and businesses alike.
Moreover, the political dividends of maintaining low inflation cannot be understated, especially when compared to the high inflation experienced under the previous administration.

Some commentators suggest that the RBI should narrow its focus, excluding food prices from its inflation target. They argue that food prices are volatile and beyond the RBI's control, and that focusing on core inflation could provide a clearer picture of underlying inflation trends. However, this proposal overlooks the fundamental public demand for stability across all consumer prices, including food, which is a critical component of everyday life for most citizens.

While food prices can trigger second-round effects — where rising costs lead to higher wage demands and overall inflation — the current economic environment of high unemployment has tempered these effects.
Nonetheless, if economic growth accelerates in the future, the risk of a wage-price spiral resurfacing could pose significant challenges. Hence, it may be premature to disregard food price signals in the inflation framework.

Instead of overhauling the IT framework, the RBI should focus on enhancing its analytical capabilities. This includes improving the quality of underlying data, which is often outdated, and refining its understanding of agricultural dynamics to discern whether food inflation is a temporary spike or indicative of deeper structural issues.

Given that the IT framework is still relatively young and is being tested by various shocks, it is prudent to adopt an incremental approach to any proposed changes. Major modifications could jeopardize the hard-won credibility of the RBI and disrupt the established trajectory towards price stability.

The RBI’s commitment to its inflation target is essential for maintaining market confidence. Any signal that the central bank may be loosening its stance could lead to increased inflation expectations, ultimately undermining the very objectives that the IT framework seeks to achieve.

In conclusion, while periodic reviews of the inflation targeting framework are necessary, it is essential to proceed with caution.
The IT framework has proven to be a successful reform, ensuring price stability and bolstering economic growth. Rather than abandoning or radically altering this framework, the focus should be on refining and strengthening it.
As the adage goes, “if it isn’t broken, don’t fix it.” Maintaining the integrity of the IT framework is crucial for sustaining India’s economic stability and ensuring that the RBI remains a credible guardian of monetary policy.