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Flexible inflation targeting has worked. We must stick to the 4% target

In August 2016, government legislated a new approach to managing inflation called flexible inflation targeting (FIT). The essence of FIT is that government, in consultation with RBI, fixed an inflation target to guide the central bank’s monetary policy. The target right now is 4% retail inflation, with a band of two percentage points on either side to provide flexibility. If average inflation goes beyond this boundary and stays there for nine consecutive months, it is regarded as failure. The life of this arrangement ends in March.

High inflation that persists has two negative effects. It hurts the economically vulnerable and will also eventually undermine fast economic growth. Keeping inflation under check has always been RBI’s main aim, but approaches have evolved with time. With FIT’s current arrangement ending in March, government should continue with the existing targets. Evidence shows that it’s met the goals and India has experienced a relatively benign phase of inflation. Also, expectations drive a modern economy. Switching inflation targets without adequate reason will erode the credibility of RBI and loosen expectations.

A common critique of FIT is that it’s blind to the economy’s need to grow. This is an incorrect argument. RBI’s legislation clearly calls for keeping inflation under check while being mindful of growth. The central bank doesn’t have a mandate to be unbalanced in managing inflation. Moreover, RBI’s record over the last two years shows that its monetary policy committee has been supportive of growth, even before the pandemic struck. If there’s a change to be made by the government, it should be to expand the ambit of policy rates to include reverse repo rate, or the interest rate at which RBI absorbs liquidity from banks. But the 4% target must stay.

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This piece appeared as an editorial opinion in the print edition of The Times of India.



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