Monetary policy framework review: RBI must keep inflation firmly in its crosshairs

First, should monetary policy target headline inflation, as presently mandated under the flexible inflation targeting (FIT) regime introduced in 2016, or core inflation (i.e., headline inflation stripped of volatile elements like food and fuel)? 

The answer to that is straightforward and RBI’s DP also seems to veer towards that conclusion; namely, that for a country like India, where food constitutes a significant share of the consumption basket (close to 46%) for a large number, it is meaningless to target core instead of headline inflation. 

The food component’s weight, in any case, is bound to decline once the Consumer Price Index is recast based on a more up-to-date Household Consumption Expenditure Survey for 2023-24, as against the 2011-12 data in use today. That exercise is already underway, so we can expect the impact of a volatile food basket to decline in the not-too-distant future.

Also Read: Should rate-setting panel track headline or core inflation? RBI stirs debate

Second, whether RBI’s current 4% target remains optimal when it comes to balancing growth with stability in a fast-growing economy. Here the DP argues in favour of the status quo on the ground that the existing framework with 4% as RBI’s central goal has served us well. We agree with that assessment. 

Despite the challenges posed in the nine years since FIT  has been in operation, including the covid  pandemic and the high inflation years that  followed, the pace of rising price levels has seen a distinct decline, with the average since FIT adoption at 4.9% vis-à-vis an average of 6.8% over the pre-FIT period.

Also Read: Mint Quick Edit | Inflation: Below target, above the worry line

Third, whether the  tolerance band of 2-6% needs to be revised (i.e., narrowed, widened or dropped altogether). Here again, we are in agreement with RBI’s contention that the “band of +/-2 per cent gives adequate flexibility to the [Monetary Policy Committee] to focus on inflation or growth depending on the evolving situation." FIT is still a work-in-progress in India. The institutional experience and memory needed is evolving. Moreover, our financial markets are not as deep as Western markets. 

The DP’s fourth question  is whether the target rate of 4% should be scrapped and only a range be maintained. The DP is against scrapping the target rate on the argument that moving to a range could be  construed as a dilution of the existing framework, which may erode policy credibility.  Notably, New Zealand, the first country to adopt inflation targeting, aimed for a range in its first 12 years before shifting to a point target. 

Also Read: RBI at fork in the road, experts back chasing headline inflation

However, we would urge RBI to end the current dichotomy between action on the policy rate and the liquidity front that often results in one working at cross purposes with the other. There have been instances in the past when the repo rate was raised only to have RBI open the liquidity tap, negating the former’s impact. 

The framework must also ensure greater transparency. As of now, the bank is required to submit a report to the government whenever the 6% FIT ceiling is breached for three consecutive quarters, but there is no mandate to make it public. The last time we had a breach—for five quarters in a row from the fourth quarter of 2021-22 to the fourth quarter of 2022-23, the report was kept under wraps. Overall, the FIT framework has served us well so far. But every review should be seen as an opportunity to improve it.