'If it ain't broke, don't fix it': RBI working paper says 4% inflation target is good for India

Recently there were speculations that the government could ask the MPC to loosen the inflation target to facilitate a growth supportive policy.

December 29, 2020 / 09:29 PM IST

A Reserve Bank of India (RBI) working paper authored by Harendra Kumar Behera and Michael Debabrata Patra has said maintaining the inflation target at 4 percent is appropriate for India.

The paper, titled ‘Measuring trend inflation in India’, said there was a steady decline in trend inflation to 4.1 percent-4.3 percent since 2014.

It said fixing an inflation target too below the trend imparts a deflationary bias to monetary policy because it will go into overkill relative to what the economy can intrinsically bear in order to achieve the target.

Analogously, a target that is fixed above trend renders monetary policy too expansionary and prone to inflationary shocks and unanchored expectations, it said.

According to the working paper, the credibility bonus accruing to monetary policy warrants smaller policy actions to achieve the target. “This points to maintaining the inflation target at 4 percent into the medium term. If it ain't broke, don't fix it,” the working paper said.

Close

Recently there were speculations that the government could ask the monetary policy committee (MPC) to loosen the inflation target to facilitate a growth supportive policy. The retail inflation has remained high in the last three quarters above the MPC’s comfort level.

The MPC has a mandate to keep inflation in the 2-6 percent range aiming 4 percent as the middle point. However, inflation has consistently remained high in recent months.

In November, the Consumer Price Index (CPI) inflation moderated to 6.93 per cent from 7.61 per cent in October.

In the latest monetary policy, the MPC retained the key policy rates, but promised to remain on an "accommodative" stance expressing willingness to support growth.

However, RBI Governor Shaktikanta Das had subsequently cautioned against any major changes in the inflation targeting framework saying such an action could dilute its effectiveness of monetary policy.

“If you make the band too wide, then targeting loses its meaning,” Governor Shaktikanta Das said in an interview to the Economic Times newspaper.

According to the RBI working paper, central to monetary policy is the concept of trend inflation to which actual inflation outcomes are expected to converge after short-run fluctuations die out.

“Accordingly, the inflation target needs to be fixed in alignment with trend inflation to avoid unhinging inflation expectations and flattening the aggregate supply curve or imparting a deflationary bias to the economy,” the working paper said.

Further, results from a regime switching model applied to a hybrid New Keynesian Philips curve suggest a steady decline in trend inflation since 2014 to 4.1-4.3 per cent just before COVID-19 struck, the paper elaborated .
Dinesh Unnikrishnan
first published: Dec 28, 2020 09:25 pm
Sections