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GS Analyst: Daily Current Affairs

21st August 2024 (10 Topics)
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RBI’s Inflation Targeting

Context

The Reserve Bank of India's (RBI) inflation-targeting regime is currently a hot topic due to ongoing debates about its effectiveness and potential need for adjustments. A recent research paper titled 'Inflation Targeting In India: A Further Assessment' highlights that while the regime has largely succeeded, some refinements could enhance its effectiveness.

What is RBI’s inflation targeting?

  • The Reserve Bank of India (RBI) adopted a Flexible Inflation Targeting (FIT) framework in 2015.
  • RBI's inflation-targeting regime was implemented in February 2015 and it got formalised in May 2016.
  • Accordingly, the government announced, via the Official Gazette, 4% Consumer Price Index (CPI) inflation as the target from August 5, 2016, with an upper tolerance limit of 6% and a lower limit of 2%.
  • This was a watershed reform as until then monetary policy in India was not governed by a clear, well-defined objective.
  • FIT gave the RBI the legal mandate of achieving price stability, while keeping an eye on growth.

Key Takeaways

  • Effectiveness of Inflation Targeting: RBI's inflation-targeting regime has helped lower and stabilize inflation, making it less volatile and improving monetary policy transmission.
  • Recommendation on Food Price Inflation: The paper suggests reducing the weight of food price inflation in the Consumer Price Index (CPI) basket. This is based on the idea that food prices are heavily influenced by supply-side factors, which monetary policy cannot directly address. Adjusting this weight could make the inflation measure more reflective of typical household experiences.
  • Current Regime Adequacy: The current inflation target of 4%, with a +/-2 percentage point tolerance band (2%-6%), is deemed broadly appropriate. The paper argues against abandoning or significantly altering this framework in favor of a more discretionary approach, which could introduce risks and inefficiencies.

Important Key Concepts

  • Inflation Targeting: This is a monetary policy strategy where a central bank sets a specific inflation rate as its goal. The RBI's inflation-targeting regime was formalized with a target of 4% CPI inflation, aiming to keep it within a range of 2% to 6%. The focus is on achieving price stability, which is crucial for economic planning and growth.
  • Consumer Price Index (CPI): The CPI measures the average change in prices paid by consumers for goods and services over time. It is a common indicator of inflation and helps central banks gauge the effectiveness of their monetary policies.
  • Tolerance Band: This is the range within which the actual inflation rate is allowed to fluctuate around the target rate. For the RBI, this is 2% to 6% around the 4% target. If inflation moves outside this range for a prolonged period, it triggers a review and response from the central bank.
  • Monetary Policy Transmission: This refers to the process through which changes in the central bank's policy rate affect economic activity, such as consumption, investment, and inflation. Effective transmission is crucial for monetary policy to achieve its targets.
  • Supply-Side Inflation: This type of inflation is caused by disruptions in the supply of goods and services, leading to higher prices. Food prices are often affected by supply-side factors such as weather conditions and agricultural output, which are not directly influenced by monetary policy.

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