Inflation Targeting - Defintion, Working, Advantages, Drawbacks, Importance And More

Inflation targeting is a central banking strategy that revolves around adjusting monetary policy to attain a stipulated annual rate of inflation. Inflation targeting is premised on the belief that long-term economic development is best attained by maintaining price stability, and price stability is attained by controlling inflation. Inflation targeting can be contrasted to other potential policy goals of central banking that involve targeting exchange rates, joblessness, or national income.

In this article, let us look at Inflation Targeting and its working, Inflation Targeting in India, who sets inflation targets in India, the necessity, benefits, and drawbacks of inflation targeting, and how successful it is from the context of the UPSC IAS Examination.

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Recent Update on Inflation Targeting in India

• Due to lower crude and edible oil prices, retail inflation in India slightly eased to 7.01% in June, compared to 7.04% in May.
• Headline inflation decreased to 0.52% from 0.94% in May, while core inflation (excluding food and fuel) stood at 6%.
• Overall food inflation was 7.75% in June, down from 7.97% in the previous month.
• Vegetable prices increased by 17.37% in June, but pulses saw a contraction of 1.02%.
• Inflation in fuel and light rose to 10.39% in June from 9.54% in May.
• The inflation figure has remained above the RBI's comfort zone of 2-6% for six consecutive months.
• Excise duty cuts on petrol and diesel and restrictions on food exports contributed to the downward trend in inflation, but it may be transitional as food prices surge due to heatwaves.
• Geopolitical factors and global product price increases continue to put inflationary pressure on supply chains.
• Pass-through of WPI inflation and high global crude oil prices leading to trade and current account deficits may further increase inflationary pressures.
• The RBI aims to keep monetary tightening to a minimum to support economic recovery amid inflation concerns.

Check out the linked article on the Monetary Policy Committee for UPSC Exams!

What is Inflation Targeting? 

Inflation targeting is a monetary policy strategy adopted by central banks. It involves setting a specific target for the inflation rate that the central bank aims to achieve. The central bank uses various tools to control the money supply and interest rates to keep inflation close to the target.

The goal is to maintain price stability and anchor inflation expectations in the economy.

Inflation targeting provides transparency and accountability for the central bank's actions in achieving its inflation objective.

History of Inflation Targeting

Following the general crisis of the gold standard post-World War I, early proposals for monetary systems shifted focus to the price level or inflation rate rather than the exchange rate. Irving Fisher suggested a "compensated dollar" system, where the gold content in paper money would adjust based on the price of goods in gold terms, maintaining a fixed price level in paper money. This marked an initial effort to target prices while preserving the automatic functioning of the gold standard.

In his 1923 work "Tract on Monetary Reform," John Maynard Keynes advocated what resembles today's inflation targeting scheme. Faced with post-World War I inflations and deflations, Keynes proposed a policy of exchange-rate flexibility. He suggested appreciating the currency in response to international inflation and depreciating it during international deflation, aiming to keep internal prices relatively stable.

Interest in inflation targeting diminished during the Bretton Woods era (1944–1971) due to inconsistency with prevailing exchange rate pegs in the three decades after World War II.

Working of Inflation Targeting

• Inflation targeting is a monetary policy approach central banks use to manage inflation. They adjust interest rates in response to above or below-target inflation.
• The central bank may raise interest rates to slow down economic activity and control inflation when inflation is above the target.
• Conversely, if inflation is below the target, the central bank may lower interest rates to stimulate economic growth and boost inflation.
• The first countries to fully implement inflation targeting were New Zealand, Canada, and the United Kingdom in the early 1990s, with Germany adopting elements of this approach earlier.

Benefits of Inflation Targeting

• Inflation targeting defines the inflation rate to be targeted in an economy, thereby giving better clarity and predictability regarding the inflation rate and monetary policy formulation.
• An increased inflation rate reduces the currency's buying power, savings, and investment rate, increases unemployment, and lowers the overall GDP growth. Larger fiscal and current account deficits also supplement it, leading to an unstable macroeconomy. Hence, low inflation would encourage investors to invest in the economy, stimulating higher growth.
• The RBI can manage the inflation rate under the Monetary Policy Framework Agreement. If the RBI fails to maintain inflation within the target, it would be obliged to explain it. Such a clause permits the RBI to have autonomy while also permitting the government to have accountability for the RBI’s actions.
• Inflation targeting has proved efficient in advanced economies like the United Kingdom and New Zealand. These economies have maintained inflation at a reasonable level for a prolonged period, resulting in improved macroeconomic stability.

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Drawbacks of Inflation Targeting

• It is unrealistic for a central bank in a developing nation like India to focus on inflation without considering the greater development context. The Reserve Bank of India (RBI) must balance growth, price, and fiscal stability.
• The trade-off between pricing and financial stability
  • Before the 2008 Global Financial Crisis, advanced economies could sustain a low inflation rate for a prolonged period, attributed to the use of inflation targeting. Inflation targeting was believed to be accountable for the nation’s overall macroeconomic stability.
  • But, the 2008 Global Financial Crisis revealed that price stability alone does not assure financial stability and that a central bank’s undue reliance on price stability may result in the negligence of other functions like regulation, resulting in an economic crisis.
  • Former RBI Governor Subbarao had stated that there is a trade-off between pricing stability and financial stability and that the more efficient a central bank is in maintaining price stability, the more probable it is to endanger financial stability.
• The last 2-3 years, the RBI has maintained inflation within the statutory range. Despite a steady inflation rate, the Indian economy is confronted with numerous hindrances. For the initial quarter of the fiscal year 2019-20, the GDP growth rate has been reduced to a 25-quarter low of 5%.
• The unemployment rate has increased to 6.1 percent, a 45-year high. Manufacturing activity has reduced, as seen by the decline in the Index of Industrial Production (IIP). The agrarian crisis is posing risks to the agriculture industry. Altogether, these illustrate that inflation targeting has failed to promote economic growth.
• Inflation targeting suits mature economies since monetary policy transmission is more effective in these nations. However, in India, the transmission of monetary policy could be more effective, thus weakening the efficiency of inflation targeting.
• To keep inflation under control, the RBI needs to increase interest rates by enforcing a contractionary monetary policy. But, this strategy would increase the rate of interest on loans, decreasing investment and consumption expenditure and reducing GDP growth rates.

Example: For 2013-2015, higher interest rates in the nation due to higher inflation rates resulted in reduced GDP growth rates.

• Inflation in India may arise due to supply-side bottlenecks, like rising crude oil prices, poor monsoon conditions, floods, etc. The present surge in tomato and onion prices is mainly due to supply-side interruptions. In such cases, the RBI’s influence in reducing inflation rates would be restricted, and the government would be obliged to deal with these supply-side disturbances to keep product prices in check.

Check out the linked article on the Index of Industrial Production (IIP) for UPSC Exams!

Is Inflation Targeting Needed?

• Inflation targeting advocates the purpose of price stability in a real monetary policy arrangement.
• Adopting price stability establishes a steady non-inflationary environment for economic resource allocation.
• Since the RBI determines a particular inflation rate as a goal, it makes the public believe that prices will continue to increase. This has some advantages, as listed below:
  • The inflation targeting benefits the economy by urging people to purchase things in the present (before their cost increases).
  • It raises investments by giving the investors the confidence that the current investments will render them a higher return when they sell them later.
• A reliable central bank and steady inflation together reduce the nation’s risk premium and cost of borrowing in an open economy.
• It also makes the RBI more responsible to the government since the RBI is obliged to give an appropriate explanation in case it violates the inflation targeting tolerance range (2-6%).

Check out the linked article on the Wholesale Price Index (WPI) for UPSC Exams!

Was Inflation Targeting a Success?

• In 2016-2021, after inflation targeting was instituted, RBI managed to keep inflation under control. The average inflation rate gauged through the GDP deflator has fallen to 3.47% in the last five years from 5.69 % in the pre-inflation targeting period.
• The inflation rate has stood within the stipulated band of 2% to 6%. According to the RBI, inflation was above 9% before introducing inflation targeting in India.
• The RBI has efficiently anchored inflationary expectations, with India being the highest achiever in lessening inflation compared to other Asian nations.
• Consumer Price Index (CPI) inflation fell from 8.26 % in 2011-2015 to 4.99 % in 2016-2019, with a 3.27 % fall, making it the highest among inflation-targeting nations and those that did not adopt it.
• India has also significantly fallen in average inflation volatility over the aforementioned period. It was 7.93 % for the five-year period before inflation targeting, which fell to 0.89 % in the inflation targeting regime, with this fall being highest in comparison to Indonesia, Thailand, Philippines, and Korea.

Check out the linked article on the Producer Price Index (PPI) for UPSC Exams!

Inflation Targeting in India

• In India, the Monetary Policy Framework Agreement between the RBI and the Indian government in 2015 constituted inflation targeting. The decision was undertaken after India had around 10% inflation rate for about five years.
• The modification to the Reserve Bank of India Act, 1934, effective in June 2016, made way for a Flexible Inflation Targeting (FIT) framework in India by defining the fundamental objective of monetary policy as preserving price stability jointly with the goal of growth.
• According to the Monetary Policy Framework agreement regulations, the RBI is entrusted to maintain a rate of inflation of 4% with a 2-percentage-point deviation, i.e., inflation needs to be retained between 2% and 6%.
• If consumer inflation is above 6% or below 2% for three successive quarters commencing in the 2015/16 fiscal year, the central bank will be deemed to have missed its goal.
• If the central bank misses to meet its inflation target, then:
  • It needs to send a report to the government justifying why and what steps it will take to rectify the problem.
  • It will also need to estimate how long it will take to restore it to the target level.

When was Inflation Targeting adopted in India?

In 2015, the RBI and the central government of India agreed on a policy framework. Reserve Bank of India Act, 1934, was modified to offer a legal basis for this framework. The Flexible Inflation Targeting (FIT) framework was thus enacted in 2016.

Who sets Inflation Target in India?

The inflation target in India is laid down jointly by the nation's central bank, which is the Reserve Bank of India, and the government of India once every five years. This is based on the RBI Act of 1934.

What is the Current Inflation Target in India?

The central government of India has notified 4 percent Consumer Price Index (CPI) inflation as the target for the time period from August 5th, 2016, to March 31st, 2021, with an upper tolerance limit of 6 percent and a lower tolerance limit of 2 percent.

Inflation Targeting across the Globe

At the beginning of 2012, about 27 nations were considered full inflation targeters by the Bank of England’s Center for Central Banking Studies, while other reports state 26-28 nations as of 2010. Since then, the USA and Japan have also created inflation targets, even though the Federal Reserve of the USA, as the European Central Bank, does not consider itself facing inflation.

Concluding Remarks

Inflation targeting has been satisfactorily practiced in several growing nations over the past 20 years, and many more nations are moving toward this framework. It will ensure openness in the central bank’s role and the economic targets for inflation. However, over a long period of time, it impedes the true potential of growth in the economy as it throttles the development to attain price stabilization. Over time, inflation targeting has been demonstrated to be a flexible framework resilient in changing circumstances, including during the recent international financial crisis. However, individual nations must evaluate their economies to decide whether inflation targeting is suitable for them or can be tailored to suit their needs. This should not be considered as a universal remedy for all the problems.

We hope that all your doubts regarding the topic of Inflation Targeting UPSC have been addressed after going through this article. Testbook gives standard quality of study notes for various competitive exams. Be successful in your UPSC exam preparations by downloading the Testbook App here!