Contents

  1. Finance Ministry’s decision for monetary policy explained

FINANCE MINISTRY’S DECISION FOR MONETARY POLICY EXPLAINED

Context:

The Central government confirmed that India’s central bank, the RBI, will continue to target maintaining retail inflation within the band of 2% to 6%.

Relevance:

GS-III: Indian Economy (Economic Growth and Development, Planning usage and Mobilisation of resources, Inclusive growth and issues therein)

Mains Questions:

RBI’s monetary policy which is based on inflation-targeting needs some reforms. In this context, what is the role of consumer price inflation in this regarding? (10 marks)

Dimensions of the Article:

  1. Background to the Finance Minister’s announcement
  2. About India’s inflation targeting
  3. What is the rate of consumer price inflation?
  4. What is the RBI’s position on this?
  5. Why should this concern consumers?
  6. How does RBI handle things?
  7. Questioning Inflation targeting
  8. Why not wider or narrower Inflation target?

Background to the Finance Minister’s announcement

  • On the last day of the financial year 2020-21, the Finance Ministry announced that the inflation target for the five years between April 2021 and March 2026 will remain unchanged at 4%, with an upper tolerance level of 6% and a lower tolerance level of 2%.
  • This is the retail inflation target that will drive the country’s monetary policy framework and influence its decision to raise, hold or lower interest rates.

About India’s inflation targeting

  • India had switched to an inflation target-based monetary policy framework in 2015, with the 4% target kicking in from 2016-17.
  • Many developed countries had adopted an inflation-rate focus as an anchor for policy formulation for interest rates rather than past fixations with metrics like the currency exchange rate or controlling money supply growth.
  • Emerging economies have also been gradually adopting this approach. In adopting a target for a period of five years, the central bank has the visibility and the time to smoothly alter and adjust its policies in order to attain the targeted inflation levels over the medium term, rather than seek to achieve it every month.
  • Terming India’s inflation trends “worrisome”, Moody’s Analytics recently pointed out that volatile food prices and rising oil prices had already driven India’s consumer price index (CPI)-based inflation past the 6% tolerance threshold several times in 2020 and that core inflation trends were rising again.

What is the rate of consumer price inflation?

  • Moody’s Analytics recently pointed out that volatile food prices and rising oil prices had already driven India’s consumer price index (CPI)-based inflation past the 6% tolerance threshold several times in 2020 and that core inflation trends were rising again.
  • Retail inflation has remained below 6% since December 2020. However, it accelerated from 4.1% in January 2021 to 5% in February.
  • While inflation headwinds remain, especially with oil prices staying high, there was some speculation that the Central government, whose topmost priority now is to revive growth in the COVID-19 pandemic-battered economy, may ease up on the inflation target by a percentage point or two. This would have given the Reserve Bank of India (RBI) more room to cut interest rates even if inflation was a tad higher.
  • That the government has desisted from doing this and left the inflation target untouched has been welcomed by economists who believe that the new framework has worked reasonably well in keeping inflation in check over the last five years.
  • They attribute the few recent instances when the upper target was breached to the exceptional nature of the COVID-19 shock.

What is the RBI’s position on this?

  • The RBI had, in recent months, sought a continuance of the 4% target with the flexible tolerance limits of 2%.
  • The 6% upper limit, it argued, is consistent with global experience in countries that have a large share of food items in their consumer price inflation indices.
  • Accepting inflation levels beyond 6% would hurt the country’s growth prospects, the central bank had asserted.

Why should this concern consumers?

  • Suppose the inflation target were to be raised to 5% with a 2% tolerance band above and below it, for consumers, that would have meant that the central bank’s monetary policy and the government’s fiscal stance may not have necessarily reacted to arrest inflation pressures even if retail price rise trends would shoot past 6%.
  • For instance, the central bank has been perhaps the only major national institution to have made a pitch for both the Centre and the States to cut the high taxes they levy on fuels that have led to pump prices for petrol crossing Rs. 100 a litre in some districts.
  • As high oil prices spur retail inflation higher, the central bank is unhappy as its own credibility comes under a cloud if the target is breached.
  • If the upper threshold for the inflation target were raised to 7%, the central bank may not have felt the need to seek tax cuts (yet).
  • Thus, the inflation target makes the central bank a perennial champion for consumers vis-à-vis fiscal policies that, directly or indirectly, drive retail prices up.

How does RBI handle things?

  • If the RBI sees that its main job is to boost growth in the economy then it could keep the interest rates lower while relaxing the regulations to enable quick and easy ways for the banking system to give out new loans.
  • Cheaper loans will make it easier for firms and governments to borrow and spend/invest — thus boosting economic growth.
  • On the other hand, if the RBI sees that its main job is to maintain financial stability and control prices in the economy, then it would keep a tight leash on the interest rates and the norms determining the provisioning of new loans. This would, in turn, constrain economic growth.

Questioning Inflation targeting

  • One argument is that, instead of headline retail inflation, the RBI should focus on the retail core inflation rate, which is the inflation rate without taking into account the fluctuations in the prices of fuel and food items. Since fuel and food prices often shoot up in the short-term due to temporary factors — say, excessive rains or some other supply disruption — it is best for the RBI to focus on core inflation. The logic being that it is the core inflation that is the most robust indicator of the rate of rise in prices. Because RBI’s move to tweak interest rate affects the credit available to businesses, which, in turn, are affected by wholesale inflation, and not retail inflation. It can be argued that if retail prices of fruits and vegetables spike due to unseasonal rains, thus pushing up retail inflation, then raising interest rates — an action that would make it costlier for all manufacturing and services firms to get a loan — will not help matters anyway.
  • Another argument is that the RBI should neither use the wholesale nor retail inflation rate as targets, and instead, it should create a Producer Price Index — a more focussed inflation rate index to best suit RBI’s need.

Why not wider or narrower Inflation target?

  • As India starts a new financial year, there is a tremendous and understandable urgency to grow fast and get back to the days of high GDP growth rate.
  • But it is also true that in the months and year ahead, as banks start recognising bad loans or non-performing assets on their books, macro-financial stability will come into sharp focus.
  • Moreover, with fuel prices staying high and another wave of Covid-induced lockdowns likely, supply bottlenecks could lead to inflation rates spiking again.

-Source: The Hindu

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