PROJECT REPORT ON

INFLATION TARGETING IN INDIA

SUBMITTED TO: SUBMITTED BY:

PROF. Dr RAKHI SINGH RITIKA RUSTAGI
19BSP2254
SECTION: F
 INFLATION TARGETING
Introduction:
Inflation means that continuous and irreversible rise within the general level of
costs. For any country, this case isn't sensible for growth and development as a
result of it discourages savings and investments. It additionally will increase
inequalities between the made and also the poor. So, to tackle inflation,
government adopts financial and monetary policies. Now a days, in most the
countries, the first goal of central banks is to attain the short run and also the
medium run, low rate of inflation. this can be done by adopting the policy of
inflation targeting.
Inflation targeting: It is a monetary policy where a central bank follows a target
for the inflation rate for the medium-term and announces this inflation target
to the public. The assumption is that the best that monetary policy can do to
support long-term growth of the economy is to maintain price stability.
Underneath this setup, the financial institution estimates and comes ‘target
inflation’ rate and so create efforts to require the particular inflation to the
target inflation. Inflation targeting (IT) may be a financial policy wherever a
financial institution sets a target for the rate of inflation for the medium-term
and announces this set inflation target to the general public. the idea is that, the
best that financial policy will do to support long growth of the economy is to
keep up worth stability.
Interest rates is that the primary tool central banks use in inflation targeting.
The financial institution can lower or raise interest rates supported whether or
not it thinks inflation is below or on top of a target threshold. Raising interest
rates is alleged to slow inflation and so slow economic process. Lowering
interest rates is believed to spice up inflation and speed up economic process.
Along with inflation target rates and calendar dates to be used as performance
measures, inflation targeting policy may additionally have established steps that
are to be taken betting on what proportion the particular rate of inflation varies
from the targeted level, like cutting disposition rates or adding liquidity to the
economy.
Inflation targeting and its context
Inflation targeting is a product of 1990’s. New Zealand and Canada were the first
to adopt an explicit target path for prices followed by UK, Finland and Israel,
Spain and Sweden. In the literature of monetary economics, inflation targeting
has an important position.
Various advanced economies including United States, Canada and Australia
have been using inflation targeting as a strategy in their monetary policy
framework. The case for inflation targeting has been made in India as the
country has been experiencing a high level of inflation till recently.
One of the countries where inflation targeting has been quite successful in
reducing both inflation and output volatility is the UK. Adoption of Inflation
targeting conferred Central Banks the liberty to differ from government
numeric. The publishing of the minutes of meeting between the Governor and
the Chancellor to the public, helped in enhancing the Central Bank’s credibility
and thereby led to formation of lower inflation expectation across consumers.
By comparing the effectiveness before and after the Bank of England gained
independence, Sterne showed that inflation targeting was successful even when
the bank was not independent. However, he observed that conditions in
emerging economies are ‘noisier’; hence the factors which led to the success in
UK should not be directly generalized to these economies.
Inflation targeting has its origin from two important issues. The first one is the
problem of credibility and the second is the problem of policy reengineering.
The Reserve Bank of India (RBI) and Government of India signed a Monetary
Policy Framework Agreement on 20th February 2015. As per the terms of the
agreement, the objective of monetary policy framework would be primarily
focussing on to maintain price stability, while keeping in mind the objective of
growth of the economy. The monetary policy framework would be operated and
controlled by the RBI. RBI aimed to contain consumer price inflation (CPI) within
6 percent by January 2016 and within 4 percent with a band of (+/-) 2 percent
for all subsequent years.
Framework of inflation targeting: Inflation targeting is a monetary policy where
the central bank sets a specific or particular inflation rate as its goal. The central
bank does this thing to make you believe that the prices will continue rising. It
stimulates the economy by making people buy things at the present before they
cost more. Most central banks use an inflation target of 2%.
IT in India Measuring Inflation
In India, mainly there are two kinds of indicator that are used to measure
inflation:
1. Wholesale Price Index
2. Consumer Price Index
Wholesale Price Index (WPI)
An index used by the Reserve Bank of India till 2014 to formulate its monetary
policy was WPI, as the name is self-explanatory, it measures the prices of the
goods at the wholesale level. WPI acts as representative for the prices of the
wholesale goods. It takes into account of 697 items and shows the combined
prices. The basket used in WPI is composed of three groups: Manufactured
Products (65 percent of total weight), Primary Articles like food, etc. (20.1
percent), and Fuel and Power (14.9 percent). The WPI is calculated by the
Ministry of Commerce and Industry of India.
The main reason RBI, ex-governor Raghuram Rajan, shifted to Consumer Price
Index (CPI) is because it neglects services and the congestion between a
wholesaler and a retailer which should be included.
Consumer Price Index (CPI)
CPI takes in to account 260 items or commodities including certain services,
measures the change in prices at the retail level. Prices of goods and services
which are to be sampled are collected time to time (usually every month or two
month) by the Ministry of Statistics and Programme Implementation. The base
year of CPI was changed from 2010 to 2012. Right now, we use this index to
calculate inflation in India.
A base year is used to compare the measure of rates. For simple understanding,
this can be taken as ‘first’ year in the time set. Prices in the base year are often
taken as 100 for the ease of calculations.
Monetary policy aims to target inflation over a horizon of 2 to 3 years. Therefore,
to target inflation, it is necessary to have the capability to build an inflation
forecast. India has yet to develop skills to forecast inflation over a range of 8 to
12 quarters. In countries which follow IT, sophisticated models are used to
forecast inflation. Similarly, there is need to forecast output and its deviation
from natural rate, implying forecasting of output gap. The other issue is the
target inflation number which needs to be identified and quantified. When
considering inflation targeting, it also has to be ascertained as to which of the
price indices to use to target inflation. Different economists have different
opinions regarding the same, so a preliminary study was conducted as to the
options that are available and their implement ability as inflation targets.
Inflation targeting will advocates what it tries to, like:
We will discuss the advantages of inflation targeting. Two of the important
advantages are:
 enhancement of transparency
 reduction of worth variability.
Also, alternative advantages of IT include:
 increased public understanding of financial policy
 increased financial institution accountability
 an improved state for economic process
 reduced relative worth variability
Now, we will be discussing about some of the disadvantages of the inflation
targeting:
 Delayed signalling
 Too much rigidity
 Potential for increased output fluctuations
 Low economic growth
Conclusions and Recommendations
After studying inflation targeting, some conclusions can be made, and these
are as follows, it is widely accepted that adoption of IT has helped most
countries reduce their inflation rates successfully. Also, it helps increase the
transparency and credibility of the central bank, thus allowing it to carry out
its monetary policy with greater effectiveness. IT helps to stabilize
inflationary expectations in an uncertain future. Also, for a few nations,
exchange rate volatility has also declined as a result of IT implementation.
But on the opposite hand, IT demands a number of conditions for its
successful implementation such as independence of central banks, well
developed financial markets, flexible exchange rate, etc. Most emerging
economies, including India, lack these conditions. Apart from this, RBI has
objectives to take care of other parameters like economic growth, stable
exchange rate and financial stability, and cannot stick to one single objective
of inflation. Inflation models used to forecast inflation by central banks,
which goes as an input to IT, fail to capture the relationship between the
financial and the real sectors. This relationship has particularly become
very important after the recent financial crisis. Also, because of the very clear
policies of the banks, the problems of moral hazard and market indiscipline
arise. Given that India was to an extent insulated from the 2008 financial
crisis chiefly because of its multi indicator approach and target financial
stability, and not just on price stability, it is advisable not to give up this
policy. Hence, implementing inflation targeting in India at this stage would
not be useful. Another very important argument against implementing IT in
India is that it is mainly designed for countries where the inflation is due to
demand factors, whereas in India, it is the supply aspect factors that are
causing inflation. The major reasons for inflation have been agricultural
vagaries due to irregular monsoons and the huge imports of oil in the
country. India is a rising economy wherever growth and rate of exchange are
quite volatile. The exchange rate in any small open economy is influenced by
many factors, including uncertainties in the global economy and not only
internal factors. Hence it becomes necessary to manage the rate of exchange
to create positive the economy is, to the extent possible, insulated from
external shocks. Another problem with implementing IT would be that the
transmission mechanism in the country is not very strong and there are a lot
of uncertainties involved in that as well. Hence, the policy manufacturers
can't be terribly positive of whether or not their efforts would yield the
specified results. All these factors once more counsel that straight away
Bharat isn't prepared for inflation targeting.
India’s monetary policies can be improved on a number of factors, such as
release of economy’s viewpoint and people’s expectations and preferences
at a regional level, information of exchange rate management by RBI and it’s
estimates of the real interest rate and liquidity in the market. Also, separating
debt management from financial management so as to create the central
bank (RBI) more independent would be a good move since currently, the RBI
is not transparent in setting its interest rate decisions as the debt
management office is also a part of it. Currently the focus of RBI and the
Government are different, controlling inflation and boosting growth
respectively. Also, the Government and the RBI should work together in
fixing the interest rates. An independent, accountable and reliable
committee can be setup for setting the interest rates which should properly
give the factors it is considering and its reasons for setting the policy rates.
Apart from the this, especially for emerging economies, some of the major
factors that need to be studied for India are also understood. It is found that
India has been performing fine with its Multiple Indicator Approach till date.
However, given the performance of India for the last 5 years, at least in terms
of inflation, the decision to stick to a multi-indicator approach among the
entire discussion about inflation targeting has been clear. Since the flip of
events when the crisis, a dual policy of price stability coupled with growth is
a sensible approach for an emerging economy. EMEs are, in general, subject
to economic shocks of higher magnitude during financial crises, and financial
stability becomes the sole objective under such circumstances. Therefore,
tally ought to continue its Multiple Indicator Approach wherever value
stability, financial stability and economic growth are considered for decision-
making. However, deducing the positives that can come out of focusing on
inflation, a greater weightage should be given to inflation in the Multiple
Indicator Approach. This would make sure that inflation doesn't exit of
bounds, but at the same time, growth would not be sacrificed for the sake of
inflation.
Moreover, other developing countries can also implement the multi-
indicator approach, with a more weightage given to the inflation factor. Like
India, these countries also do not have an effective mechanism, flexible
exchange rate and many other necessary conditions for IT implementation.
Adopting the multi-indicator approach would not be difficult for these
countries, given that price stability and economic growth is already a concern
they have been completely fighting for.
Other recommendations would be to specialize in the new CPI that's
additional representative and provides regional characteristics. Also, the new
CPI includes services and hospitality sector, which is a must for a country like
India that is booming in services. This conjointly confirms why a Multiple
Indicator Approach is that the manner forward for Bharat.
The demographic factors are also need to be considered while managing
inflation. India, which is unique given its young demographic status, should
show interest in the desire and consumption demand of its young population
and focus more on employment generation and growth, rather than low
inflation rate only based on the experiences of other advanced countries.
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