Targeting inflation at 4 percent

October 13, 2014

Finance Minister Arun Jaitley seems to have finally taken the responsibility of targeting inflation as it is a sensitive political issue and could not be left to the discretion of the Reserve Bank of India (RBI). With CPI as the anchor, the target will be 4 percent measured annually (+/-2 percent).

Inflation has been a bone of contention for nearly three years now. The RBI has kept the repo rate a wee bit above inflation rate on the supposition that inflation will go down and growth will follow. But the finance ministry wanted the interest rate to be low enough to stimulate growth, which has almost halved in the past two years. The RBI had the upper hand in deciding interest policy because it enjoys autonomy and need not go by the insinuations of the finance ministry.

With a new government at the centre, perceptions have also changed. Picking on the RBI’s suggestion made way back in January, the finance ministry has proposed to decide the inflation target.

Surely, the government has an ear on the pulse of the people and can assess what level of inflation would be acceptable. An average of 4 percent inflation would mean that the repo rate would be 5-6 percent and bank credit 7-8 percent. That should create the right environment for growth.

Inflation targeting is a good game and not a difficult one. The real problem is in achieving the target. In the last four years, it was left to the RBI to use the monetary policy to tame inflation and it failed miserably. The question is why?

First, we have a large agricultural sector which, even now, depends on uncertain monsoons. There is also a built-in mechanism which tends to perpetuate inflation once it takes off. Procurement prices of food grains, for instance, are increased almost every season, resulting in food subsidy increase and budget deficit.

Further, linking of wages to the cost of living – in which food basket has heavy weight – means that agricultural prices raise wages, which in turn increases the cost of manufacturing and services. Inflation spreads and gets out of hand. Also, India is not an open economy. This makes the supply side inflexible and shortages perpetuate.

What’s really needed is to understand the nature of inflation and identify the role of government and the RBI in correcting it. The present four-year-old run of inflation is essentially due to shortages of fruits and vegetables, meat and eggs. This is because increase in production has been slow and not supplemented with imports.

Some inflation is necessary to prevent the economy from falling into recession. The U.S., EU and Japan are struggling to spur inflation with low or negative interest rates because they have realized that zero inflation means zero growth.

When inflation exceeds the target, both monetary and fiscal tools should be used to bring it down. If the government fixes the target, it also has to assume equal responsibility in controlling it.

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