Inflation Targeting : The Challenges Ahead

Tue, 23 Aug Pre-Open

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Sometime back, earlier this month, we wrote on India's obsession with inflation and why it is set to grow. Here's a snippet, in case you missed it:

Let us limit our focus on the Indian inflation story today. For Indians, inflation has become the same old. And the situation is said to remain the same; or even get worse maybe. One of the reasons to this is recent development with respect to Goods and Service Tax or GST.

The article shed light on various practicalities of GST and how the same would mean an increased inflation for India. It also stated other causes that have led to higher inflation in India.

The inflation story is indeed a fact that remains as a stain on the Indian economy. Many factors that feed the inflation monster are treated with scant importance.

However, at the same time, there are also some developments introduced recently to defy this norm. Take the government's inflation targeting for instance. The government announced an inflation target of 4%, plus or minus 2%. It also set up a monetary policy committee (MPC) for this inflation-targeting regime. The span, during which the MPC will have to adhere to this target, is set up until 31 March 2021.

No doubt this is a great step forward to control the growing inflation in India. The real challenge, however, is that there stand many hurdles ahead for this flexible inflation targeting. We came across an article from the Hindu Business Line that highlights some of them.

First we have the problem of rising food inflation. Moreover, as the article states, inefficient containing of services sector inflation has hobbled agriculture and led to higher food inflation. Why this matters is because food articles account for around 46% of the CPI basket - the metric chosen for inflation targeting mechanism. So rising food price inflation could mean higher CPI and in turn breach the inflation target set by the government. Being on the topic, Vivek Kaul, editor of Vivek Kaul's Diary, has explained some of the causes of rising food inflation in India.

Second is the rise witnessed in services sector inflation. The services sector inflation has averaged about 5.8% since the inception of the CPI index in January 2012. Further, sub-indices such as health and education have averaged about 6.2% and 7.6%, respectively. So rising inflation here will be a key variable that will influence the CPI and pose threat to the inflation target set.

Further, upcoming events such as the Pay Commission awards and GST implementation could have near-term impact of enhanced consumption demand and would mean an increase in the CPI.

The major concern in the room is the underlying metric used to measure the above target. The underlying metric chosen for the inflation-targeting mechanism is the consumer price index (CPI). This is worrisome because CPI comprises of a volatile series. And greater volatility witnessed here would mean a breach in the abovementioned proposed targets.

There's also the question of autonomy. The target can be achieved only if the RBI is given operational freedom. It should be free of government's intervention and the political drama. With Urjit Patel appointed as the new RBI Governor, we can be assured that Rajan's legacy of keeping inflation target in check will continue. However, the focus on inflation also remains as one of the biggest challenges for Urjit Patel. Vivek Kaul, editor of Vivek Kaul's Diary, has addressed this issue and answered what can one expect from the new RBI Governor in one of his recent articles. By doing so he has stressed that with inflation levels at nearly two-year high, it is important that the focus on inflation is retained.

Lastly, we believe that India needs more of structural reforms rather than temporary monetary stimulus. Low inflation target for some years ahead will surely give the assurance of well being. However, without structural changes, it also raises doubts regarding its longevity.

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