‘If It Ain’t Broke, Don’t Fix It,’ Says RBI Paper Backing 4% Inflation Target

A study by the Reserve Bank of India points to maintaining inflation target at 4% in the medium term.

The central bank on Dec. 28 published a working paper titled “Measuring trend inflation in India”, ahead of the inflation target review in March 2021. The RBI’s inflation target, reviewed every five years, is set at 4% with a symmetrical tolerance band of +/- 2%. The central government, which determines the inflation target in consultation with the central bank, was earlier reported to be considering a looser inflation target to enable more focus on economic growth as inflation remained well above target for most of the year.

However, while inflation expectations aren’t yet fully anchored to the target, convergence is underway. The working paper found that since 2014, when the 4% target was first set, trend inflation in India has shown a steady decline, easing to 4.3% in the quarter ended March, ahead of the Covid-19 pandemic.

While the output gap and inflation rate turned out to be volatile since 1980, the amplitude of fluctuations in the inflation rate appears to have reduced over time, especially with the adoption of flexible inflation targeting, according to the paper. The findings indicate trend inflation stood at 6% until 2012, falling significantly thereafter, coinciding with the adoption of inflation targeting at 4% as the primary objective of monetary policy in India.

The decline in trend inflation is underlined by a decline in the inflation persistence, indicating that households and businesses in India are becoming more forward looking than before as credibility associated with monetary policy increases. This is accompanied with an increase in sacrifice ratio—further disinflations will become costlier in terms of the output foregone, the paper said. At the same time, the credibility bonus accruing to monetary policy warrants smaller policy actions to achieve the target, the paper authored by Deputy Governor Michael Patra and Harendra Kumar Behera said.

Trend inflation still remains above the target under flexible inflation targeting, although it’s on a declining trajectory, the paper said. Trend or steady state inflation is the level to which actual inflation outcomes are expected to converge after short-run fluctuations. As such, the inflation target needs to be fixed in alignment with trend inflation to avoid unhinging inflation expectations and flattening the aggregate supply curve or imparting a deflationary bias to the economy, the paper said.

“A target set below the trend imparts a deflationary bias to monetary policy because it will go into overkill relative what the economy can intrinsically bear in order to achieve the target,” the paper said. “Analogously, a target that is fixed above trend renders monetary policy too expansionary and prone to inflationary shocks and unanchored expectations,” it added. As such, the optimal approach is to set the inflation target in broad alignment with or slightly below trend inflation.