In the press conference following the recent Monetary Policy Committee (MPC) meeting on June 8, the Reserve Bank of India introduced a new terminology, “aligning with the (inflation) target”, to describe the objective of its future monetary policy actions. In an inflation targeting regime, clear communication by the central bank plays a key role in setting expectations of economic agents. The introduction of this new terminology could inadvertently create ambiguity which could end up hurting the credibility of the inflation targeting framework.
The RBI is legally mandated to achieve a 4 percent CPI (consumer price index) inflation target, with a band of (+/-) 2 percent around it. For some time, this legally mandated target was not achieved. For five consecutive quarters average inflation exceeded the upper threshold of the RBI’s tolerance band. CPI inflation averaged 6.6 percent between January 2022 and March 2023. Since then, inflation has been cooling off, with CPI during March-May 2023 averaging 4.9 percent.
Change In Strategy?
The law is clear that the RBI’s policy actions must be geared towards achieving the 4 percent target. However, in the press conference on June 8, in response to questions from journalists, the RBI introduced a new phrase to communicate its future strategy. When asked about the factors that may prompt the MPC to start cutting rates, the RBI said that its comfort zone was when inflation “aligns with the target”, and that it was looking at “inflation aligning with the target, not with inflation at the target.” In response to questions related to monetary policy stance, the RBI responded by saying that its endeavour will be to see that “inflation aligns with the target on a durable basis”.
The use of terms such as ‘alignment’ or ‘aligning’ could be confusing for several reasons.
First, it is not obvious how “alignment” fits into a rule-based inflation targeting framework, where the objective of monetary policy has been defined using precise language. The Monetary Policy Framework Agreement that established the inflation targeting regime in February 2015 clearly states that the target for all subsequent years shall be 4 percent and the policy rate or other monetary measures will be determined to achieve the target.
Consequently, when CPI inflation exceeds the tolerance band, there are two steps to achieving the inflation target. One is to bring inflation within the band and the second is to achieve the central target. Now that CPI inflation has stayed within the band for three consecutive months, it can be assumed that the first part of the strategy has worked. What remains to be done now is to design monetary policy such that the 4 percent target is achieved. Inflation aligning with the target is neither a part of the first step nor is it synonymous with the second.
Second, it is difficult to understand what “aligning with the target” implies in the context of monetary policy. According to the Oxford and Webster dictionaries, “aligning” means “bringing in line”, and so we may conject
that the RBI wants to bring inflation in line with the 4 percent target. Still, it is not clear what this means operationally. Is it when CPI inflation has remained within the 4 to 5 percent range for a certain number of months? Or is it when inflation has remained at a specific level close to the 4 percent target for a few consecutive months? Or is the definition of “aligning” left to the discretion of the RBI?
Confusing Signals
This also generates uncertainty about the RBI’s expected policy response. A good communication strategy should help the financial market anticipate the RBI’s next policy action when new data on CPI inflation is released. Now that the RBI seems to be focusing on aligning inflation with the target, the market is left guessing about when the RBI will change its policy stance or when it will consider lowering the policy rate.
Third, this ambiguity has a real cost. Monetary policy works if banks change their interest rate in response to RBI actions, and firms set their prices on the assumption that the RBI will curb inflation. For economic agents to do this they need to clearly understand the RBI’s objectives and be convinced that the central bank’s strategy will work. Consider what would happen if inflation remains in the 4-5 percent range for the next several months. Banks and financial markets will be unsure how the RBI would react: whether it would maintain its stance, on the grounds that inflation is above the 4 percent target or start lowering its policy rate, on the grounds that inflation is now “aligned” with the target. It is not clear. They would accordingly be unsure about where they should set their own interest rates.
Fourth, the inflation targeting framework in India is still at a nascent stage. Over the last 15 months, the target has been consistently missed. And now the RBI says that they are looking at “inflation aligning with the target, not with inflation at the target”. We are at a critical juncture when careful attention must be paid to reinforcing the credibility of the framework. The best way to do this would be to clearly and unambiguously state that going forward the RBI will be focused on achieving the 4 percent target.
All over the world, inflation targeting central banks use limited and precise language to communicate their monetary policy strategy for the sake of transparency and accountability — two critical pillars of an inflation targeting regime. It would strengthen the credibility of India’s inflation targetting framework if the RBI also sticks to a well-understood lexicon.
Rajeswari Sengupta is Associate Professor of Economics, IGIDR, Mumbai and Harsh Vardhan is a Management Consultant & Researcher based in Mumbai. Views are personal, and do not represent the stand of this publication.
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