6. Economics Notes 09

Elaborate Notes

Inflation Targeting in India

Inflation Targeting is a monetary policy framework wherein the central bank explicitly sets a medium-term inflation rate as its primary goal, and uses its policy tools (like the repo rate) to achieve that target.

• Definition and Framework: In India, this framework is known as Flexible Inflation Targeting (FIT). It was formally adopted in 2016 through an amendment to the Reserve Bank of India Act, 1934. The government, in consultation with the RBI, sets the inflation target once every five years. The current target, set for the period April 1, 2021, to March 31, 2026, is 4 per cent for the Consumer Price Index (CPI) Combined, with a tolerance band of +/- 2 per cent. This means the acceptable inflation range is 2% to 6%.
• Historical Context - The Urjit Patel Committee: The move towards FIT was based on the recommendations of the Expert Committee to Revise and Strengthen the Monetary Policy Framework, chaired by then-Deputy Governor Dr. Urjit R. Patel (2014). The committee was constituted to address the “dual dilemma” faced by the RBI: trying to simultaneously control high and volatile inflation while also supporting economic growth, often with conflicting policy actions. The committee argued that price stability is a necessary precondition for sustainable growth and recommended making CPI inflation the nominal anchor for monetary policy.
• Monetary Policy Committee (MPC): The RBI Act amendment also established a six-member Monetary Policy Committee to decide the policy repo rate required to achieve the inflation target. This institutionalized the decision-making process, moving it from the sole discretion of the RBI Governor to a committee-based approach, enhancing transparency and accountability.

Rationale for Using Consumer Price Index (CPI)

The choice of CPI as the anchor for inflation targeting is based on several key considerations, reflecting global best practices.

• Relevance to Households: The policy chain moves from production (Producer Price Index - PPI), to wholesale (Wholesale Price Index - WPI), and finally to the consumer (CPI). CPI measures the price changes at the final stage of consumption, directly reflecting the cost of living and the purchasing power of the common person. Central banks globally, including the US Federal Reserve and the European Central Bank, target consumer-level inflation for this reason.
• Composition of CPI-Combined: This index is compiled by the National Statistical Office (NSO) and gives a comprehensive picture by combining price data from both rural and urban areas. The basket of goods and services is based on consumption patterns identified in the Consumer Expenditure Survey.
• Weightage: The highest weight in the CPI basket is given to ‘Food and Beverages’ (45.86%), followed by miscellaneous items, housing, and fuel and light. The significant weightage of food items reflects the consumption pattern of an average Indian household. This, however, also poses a major challenge for the framework.

Challenges of Inflation Targeting in India

While FIT has brought more clarity and predictability to monetary policy, it faces significant challenges in the Indian context.

• Growth-Inflation Trade-off: An aggressive focus on containing inflation, especially by raising interest rates, can make credit more expensive. This can dampen investment and consumption, thereby slowing down economic growth. This classic trade-off, often explained by the Phillips Curve concept, is a central challenge for a developing economy like India which has a strong imperative for high growth.
• Ineffective Monetary Policy Transmission: This refers to the lag and incompleteness with which the central bank’s policy rate changes are passed on by commercial banks to their lending and deposit rates. Factors hindering transmission in India include the rigidity of deposit rates (especially due to competition from small savings schemes like PPF), high levels of Non-Performing Assets (NPAs) on bank balance sheets, and administrative costs. The shift to external benchmarking was a major step to address this.
• Lack of Fiscal-Monetary Coordination: Monetary policy cannot operate in a vacuum. Expansionary fiscal policy (e.g., increased government spending, income support schemes like MGNREGA or PM-KISAN) puts more money in the hands of the people, increasing aggregate demand. This can fuel inflation, working at cross-purposes with the RBI’s contractionary monetary policy aimed at curbing inflation.
• Prevalence of Supply-Side Shocks: A significant portion of inflation in India, particularly food and fuel inflation, is driven by supply-side factors or cost-push shocks. These include erratic monsoons affecting agricultural output, disruptions in global supply chains, or rising international commodity prices (e.g., crude oil prices due to the Russia-Ukraine conflict or OPEC decisions). RBI’s monetary tools are primarily designed to manage aggregate demand (demand-pull inflation) and are largely ineffective in controlling such supply-driven price rises.

Positives of Inflation Targeting

• Protects the Poor: High inflation acts as a regressive tax, disproportionately hurting the poor and those with fixed incomes, as their purchasing power erodes much faster. By maintaining price stability, FIT helps protect the real income of the most vulnerable sections.
• Promotes Sustainable Growth: A stable and predictable inflation environment reduces uncertainty for businesses, encouraging long-term investment and contributing to sustainable economic growth.
• Anchors Inflationary Expectations: A clear and credible inflation target helps in managing the expectations of households and businesses about future inflation, which in turn helps in keeping actual inflation low and stable.
• Maintains Currency Value: Persistent high inflation can lead to the depreciation of the domestic currency, affecting trade and capital flows. Price stability contributes to a stable currency value.

External Benchmarking and Monetary Transmission

To improve the transmission of monetary policy, the RBI mandated banks to link their floating rate loans to an external benchmark from October 1, 2019.

• Mechanism: Banks can choose from benchmarks like the RBI’s repo rate, Government of India 3-Month or 6-Month Treasury Bill yield, or any other benchmark published by the Financial Benchmarks India Pvt. Ltd. (FBIL).
• Benefits:
  1. Transparency: The benchmark is external and publicly available, making it easier for borrowers to understand how their loan interest rates are determined.
  2. Faster Transmission: Any change in the policy repo rate by the RBI gets transmitted much more quickly to the end borrower compared to the earlier internal benchmark regimes like the Base Rate or MCLR. Banks are required to reset the interest rates at least once every three months in line with the external benchmark.

Key Monetary Policy Instruments

• Marginal Standing Facility (MSF): Introduced by the RBI in May 2011, MSF is a window for scheduled commercial banks to borrow overnight from the RBI in emergency situations when their inter-bank liquidity dries up completely.
  • Rate: The MSF rate is a penal rate, typically set 25 basis points (0.25%) above the policy repo rate. It acts as the ceiling of the policy rate corridor.
  • Collateral: Banks can pledge government securities from their Statutory Liquidity Ratio (SLR) quota, which is not permitted under the standard repo window.
  • Limit: The borrowing is limited to a certain percentage of the bank’s Net Demand and Time Liabilities (NDTL), currently capped at 3% of NDTL.
• Bank Rate: This is a long-term lending rate at which the RBI lends to commercial banks, typically without any collateral. Historically, it was a key policy tool but lost its significance with the advent of the Liquidity Adjustment Facility (LAF) in 2000. Today, it serves primarily as a penal rate charged to banks for not meeting their CRR or SLR requirements. The Bank Rate is aligned with the MSF rate.
• Standing Deposit Facility (SDF): Introduced in April 2022, the SDF is a tool for the RBI to absorb excess liquidity from commercial banks.
  • Mechanism: It allows banks to park their surplus funds with the RBI on an overnight basis.
  • Key Feature: Unlike the Reverse Repo, the SDF is a collateral-free instrument. This means the RBI can absorb liquidity without being constrained by the stock of government securities it holds. This was a key recommendation of the Urjit Patel Committee (2014).
  • Rate: The SDF rate is typically set 25 basis points (0.25%) below the policy repo rate and now acts as the floor of the policy rate corridor.
  • SLR Status: The funds parked by banks under the SDF are eligible to be counted as part of their SLR requirement.
• The Policy Corridor (LAF Corridor): This is the spread between the RBI’s lending rate (ceiling) and its borrowing rate (floor). With the introduction of SDF, the corridor is now defined by the MSF rate at the upper end and the SDF rate at the lower end. Currently, the width of the corridor is 50 basis points (Repo+0.25% to Repo-0.25%).

Qualitative Tools (Selective Credit Controls)

These tools are used by the RBI to regulate the flow of credit to specific sectors of the economy, rather than controlling the overall volume of credit. The Banking Regulation Act, 1949 empowers the RBI to use these tools.

• Fixation of Margin Requirement: The margin is the proportion of a loan’s value that the borrower must finance from their own funds. For example, if the margin requirement for a loan against shares is 40%, a borrower pledging shares worth ₹1 lakh can only get a loan of ₹60,000. By increasing the margin, the RBI can discourage borrowing for a specific purpose (e.g., to curb speculation in the stock market), and by decreasing it, it can encourage credit flow. Loan-to-Value (LTV) ratio is an inverse concept; a lower LTV means a higher margin requirement.
• Consumer Credit Regulation: This involves regulating the terms and conditions for consumer loans, such as setting minimum down payments or maximum repayment tenures for loans on consumer durables (e.g., cars, electronics). During inflationary periods, the RBI can tighten these regulations to curb consumption demand.
• Moral Suasion: This is an informal method where the RBI uses persuasion and requests to induce banks to follow certain policies in the larger economic interest.
• RBI’s Monetary Policy Stances:
  • Accommodative: Indicates the central bank is willing to cut interest rates or keep them unchanged to boost growth. A rate hike is off the table.
  • Neutral: The central bank can either increase or decrease the policy rate depending on evolving macroeconomic conditions.
  • Calibrated Tightening: Indicates that the central bank is likely to increase the policy rate or keep it unchanged, but a rate cut is not an option. The focus shifts towards controlling inflation.
  • Hawkish: A more aggressive anti-inflationary stance, signaling a strong commitment to raising interest rates to curb high inflation, even at the cost of some growth.

Prelims Pointers

• Inflation Target: Set by the Government of India in consultation with the RBI once every five years.
• Current Target (2021-26): 4% with a tolerance band of +/- 2% (i.e., a range of 2% to 6%).
• Inflation Metric: Consumer Price Index (CPI) - Combined.
• CPI compiled by: National Statistical Office (NSO), Ministry of Statistics and Programme Implementation.
• Highest Weightage in CPI Basket: ‘Food and Beverages’ group (45.86%).
• Monetary Policy Committee (MPC): A six-member committee that decides the policy repo rate.
• Urjit Patel Committee (2014): Recommended the Flexible Inflation Targeting (FIT) framework and the establishment of the MPC.
• Marginal Standing Facility (MSF): Overnight emergency borrowing facility for scheduled commercial banks.
• MSF Borrowing Limit: Up to 3% of the bank’s Net Demand and Time Liabilities (NDTL).
• MSF Rate: Currently equal to the Bank Rate. Acts as the ceiling of the LAF corridor (Repo Rate + 0.25%).
• Bank Rate: A long-term lending rate, now primarily used as a penal rate for banks failing to meet reserve requirements.
• Standing Deposit Facility (SDF): A collateral-free instrument for RBI to absorb surplus liquidity from banks.
• SDF Rate: Acts as the floor of the LAF corridor (Repo Rate - 0.25%).
• SDF and SLR: Funds parked under SDF can be reckoned for the SLR requirement.
• Policy Corridor: The spread between the MSF rate (ceiling) and the SDF rate (floor).
• External Benchmarking: Mandated by RBI since October 1, 2019, to improve monetary policy transmission.
• LTRO (Long-Term Repo Operations): A tool used by RBI to inject liquidity for a longer duration (one to three years) at the prevailing repo rate.

Mains Insights

1. The Inflation Targeting Debate: Appropriateness for a Developing Economy

• Viewpoint 1 (For FIT): The adoption of the Flexible Inflation Targeting (FIT) framework, as recommended by the Urjit Patel Committee, has been a significant reform. It has brought credibility, transparency, and predictability to monetary policy. By anchoring inflationary expectations, it creates a stable macroeconomic environment conducive to long-term investment and sustainable growth. Price stability is viewed as a necessary public good, especially protecting the poor from the erosive effects of inflation.
• Viewpoint 2 (Against a Rigid FIT): Critics argue that a singular focus on CPI inflation is ill-suited for India, where a large part of inflation is driven by supply-side shocks (food and fuel), which are beyond the control of monetary policy. An overly hawkish stance to control such inflation can choke economic growth, which is a primary developmental objective. This highlights the classic growth vs. inflation dilemma. A more flexible approach that gives equal weightage to growth objectives is often advocated for a complex developing economy like India.
• Analysis: The Indian framework is “Flexible” Inflation Targeting, which gives the MPC the latitude to look through transient supply shocks and support growth when inflation is within the tolerance band. The challenge lies in balancing the two objectives, especially during periods of stagflation (high inflation and low growth).

2. The Imperative of Fiscal and Monetary Policy Coordination

• Cause-Effect Relationship: The effectiveness of RBI’s monetary policy is significantly influenced by the government’s fiscal policy. A loose fiscal policy (high fiscal deficit financed by borrowing) can increase aggregate demand and interest rates, “crowding out” private investment and counteracting the RBI’s efforts to manage inflation and growth.
• Example: If the RBI is tightening its policy by raising the repo rate to curb inflation, but the government simultaneously announces a large fiscal stimulus package, the two policies work at cross-purposes. The fiscal stimulus would fuel the very inflationary pressures the RBI is trying to contain.
• Way Forward: Effective policy outcomes require strong coordination. This involves aligning the stances of both policies, ensuring the government’s borrowing program is in sync with market liquidity conditions, and collaborative efforts to address structural issues like supply-side bottlenecks.

3. Monetary Policy Transmission: A Persistent Challenge

• Problem: Ineffective or incomplete transmission means that the benefits of RBI’s policy rate cuts do not fully reach borrowers, and rate hikes are not fully reflected in deposit rates, blunting the impact of monetary policy.
• Structural Impediments:
  1. Dominance of Administered Rates: Interest rates on small savings schemes (like PPF, Senior Citizen Savings Scheme) are administered by the government and are often revised with a lag, making it difficult for banks to lower their deposit rates and, consequently, their lending rates.
  2. Bank Balance Sheet Health: Banks with high NPAs may be hesitant to lower lending rates to protect their profit margins.
  3. Market Structure: The dominance of a few large public sector banks can also lead to rigidities in the system.
• Reforms and Analysis: The mandatory shift from internal benchmarks (Base Rate, MCLR) to External Benchmark Lending Rates (EBLR) has been a significant step towards improving transmission. While transmission to lending rates has improved markedly under the EBLR regime, the transmission to deposit rates remains slower, impacting bank profitability and the incentives for savers.

4. The Evolving Toolkit of the RBI: From Conventional to Unconventional

• Evolution: The RBI’s toolkit has evolved to address the complexities of the modern financial system. The introduction of the SDF is a prime example. It resolves the RBI’s constraint of needing government securities to absorb liquidity, making it a more robust tool to manage liquidity surpluses, which became a major issue post-demonetization and during the COVID-19 pandemic.
• Unconventional Measures: During the COVID-19 crisis, the RBI deployed unconventional tools like Long-Term Repo Operations (LTROs) and Targeted Long-Term Repo Operations (TLTROs). These were not just about managing overall liquidity but about directing credit to specific stressed sectors of the economy for longer tenures, showcasing a more proactive and targeted approach to monetary management during a crisis.
• Analytical Insight: This evolution demonstrates the central bank’s adaptability. The shift from a broad-based quantitative approach to using more targeted and nuanced instruments reflects a deeper understanding of the Indian economy’s structural features and challenges.