Lens of Inflation Targeting
Present circumstances:
- Rate rises have been suspended by the Reserve Bank of India (RBI).
- Since May of last year, the RBI had been kicking excessive inflation, trying to bring it down to the target level of 4% by frequently boosting interest rates.
The RBI’s involvement in lowering inflation:
- The RBI is one of the central banks tasked with maintaining inflation within the target range. It generally achieves this through raising interest rates in the economy.
- Higher interest rates limit economic growth since all loans become more expensive. Fundamentally, and this is the most important factor, the RBI decreases overall demand in order to close the supply and demand gap, which lowers prices.
- For instance, the Federal Reserve in the US has been increasing interest rates to achieve its aim of 2% inflation, which has lowered overall demand and economic activity.
- But by doing so, the Fed greatly increases the risk of a recession in the American economy. The Fed may not want a recession, but after a certain point, given that it must achieve the 2% inflation objective, it is expected to care less.
What does the RBI’s inflation target look like?
- Section 45ZA of the RBI Act of 1934, which mandates that it must sustain inflation with an upper tolerance limit of 6% and a lower tolerance limit of 2%, grants the RBI more discretion than the US Federal Reserve.
Why was RBI’s decision a surprise?
- The inflation rates for January and February were 6.5% and 6.4%, respectively, keeping with the previous numbers.
- The RBI has a legal margin of error of +/- two percentage points on either side of 4%, without a doubt. According to this, the RBI needs inflation to remain within a safe range of 2% to 6%.
- decided to assess the results of the previous repo rate rise.
The monetary policy committee’s members are:
- The Monetary Policy Committee (MPC), which the Central Government formed in accordance with Section 45ZB of the RBI Act of 1934, selects the policy interest rate required to achieve the inflation objective.
It has six individuals:
- Ex officio members include the Deputy Governor of the Bank, who is in charge of Monetary Policy, and one officer of the Bank will be chosen by the Central Board. The Chairman of the Board will be the Bank’s Governor.
- The search and selection committee’s three central government nominees for the MPC will hold their positions for terms of four years, and they are not eligible for reappointment.
What could be the reason behind the RBI’s pause?
- RBI voted 4-2 to increase repo during the most recent meeting in February by 25 basis points. In opposition to the hike, one of the two dissenting members—both were government nominees—raised the following concerns: Her key points are as follows:
- Perhaps it’s time for the government to use fiscal policy to help bring down inflation.
- Moreover, petrol prices and excise taxes need to be decreased since “pockets of supply limitations and the major commodity component in India’s consumer pricing basket respond quicker to fiscal action.” In other words, monetary measures alone were insufficient to manage inflation and fiscal (i.e., connected to government spending and taxation) action was required when supply limitations and costs drive up inflation rather than when demand drives it down.
- Additionally, since supply-side bottlenecks are what drive inflation, increasing the repo rate will be futile.
- Finally, and most importantly, she advocated against raising interest rates because doing so would hurt GDP and make it more difficult to lower inflation generally.
How well does inflation-targeting work?
- In India’s case, inflation is caused by supply costs and bottlenecks rather than a hot economy, which runs counter to the notion that an overheating economy experiences inflation because demand exceeds supply.
- As a result, supply shocks that originate in and affect the food economy commonly lead to inflation in India. But, just raising interest rates has little benefit and might even be detrimental.
Conclusion:
- As demand and supply dynamics are what drive inflation, raising interest rates may result in a reduction in the money supply and inflation control, but it would limit economic growth.
- Assuming that supply-side factors are primarily to blame for India’s inflation. Hence, the MPC should evaluate both supply and demand factors.
