Review of India's Monetary Policy Framework
The Reserve Bank of India (RBI) has released a discussion paper on revising the monetary policy framework, reflecting on four pivotal questions. The RBI Act of 2016 established the flexible inflation targeting (FIT) framework, mandating the RBI to maintain price stability with a focus on growth. The target inflation rate, set at 4% with a tolerance of two percentage points, is reviewed every five years, with the current target valid until March 2026.
Significance of Flexible Inflation Targeting (FIT)
- FIT Framework: Enhanced policy transparency and improved communication with an explicit inflation target.
- Monetary Policy Committee (MPC): A six-member panel decides the policy repo rate to maintain the inflation target.
- Consists of three RBI members, including the governor, and three external members.
- Introduced transparency and reduced prior tensions between the RBI and the Union government.
- More split decisions in MPC meetings indicate robust decision-making.
Impact of FIT
- Inflation Rates: Since the FIT adoption, India's average inflation rate has been 4.9%, compared to 6.8% pre-FIT.
- Global Trends: Inflation increased globally post-pandemic, yet FIT remains widely adopted.
Considerations and Recommendations
- Headline vs. Core Inflation: Targeting headline inflation aligns with public perception and international practice, except in Uganda.
- Removing significant items like food, which is 46% of the consumption basket, could undermine credibility.
- 4% Target and Tolerance Band: This target was set after analyzing empirical evidence; maintaining it continues to be beneficial.
- As food's share in CPI reduces, a narrower band might be feasible in the future.
- Point Target vs. Range: A point target ensures clarity and credibility; shifting to a range could complicate policy formulation and communication.
In conclusion, the FIT framework has effectively stabilized inflation in India, and there is currently no compelling reason to alter it, thus ensuring policy certainty amid increasing economic uncertainties.