The 4% and +/- 2% target cycle for inflation under the Flexible Inflation Targeting (FIT) approach comes to an end this fiscal (March 31, 2021).
With the government tasked to notify the revised numbers, here is a look at how the target so far has worked.
What is FIT?
The Flexible Inflation Targeting (FIT) approach has served the RBI’s monetary policy for the last four years.
Inflation was the primary, clear target of this approach.
The FIT worked with a band that specified a target for inflation at an average of 4%.
It was however open to swinging up or down by two percentage points.
How does it work?
The adoption of FIT through a legislative mandate on September 29, 2016 was a landmark decision.
It worked as a milestone in the monetary and fiscal interface.
India since then followed a contractual approach of inflation targeting.
Under this, the government decides and notifies the target.
It gives the RBI the operational independence to operate its policy instruments to deliver on the agreed target.
How has FIT performed?
Since the inception of FIT in 2016, GDP growth starting 2016-17 and ending 2019-20 stood at 8.26, 7.04, 6.12 and 4.18 (all in Y-o-Y and in percentage terms).
In the same period, the average inflation rate was at 4.5, 3.6, 3.4 and 4.8 (in percentage terms).
So in the first four years, the mandate has been met.
To that extent, it can be said that the monetary policy has been effective.
What is the recent inflation scenario?
The COVID-19 pandemic has put severe pressure on the monetary policy objective.
There was an unprecedented contraction in the growth rate of 23.9% in Q1 and 7.5% in Q2 of 2020-21, and an estimated contraction of 7.7% for fiscal 2020-21.
Worryingly, the headline inflation rate remained above the upper band of 6% for eight consecutive months during the period April–Nov 2020.
However, the December 2020 CPI inflation is at 4.59% on Y-o-Y basis.
This was mainly on account of deceleration in food inflation by 3.87%.
The Monetary Policy Committee (MPC) in its December 2020 resolution had stated that the inflation rate will come down to 5.8% in Q4 of 2020-21, with risks broadly balanced.
Thus, the RBI is hopeful of returning to the target as soon as the supply side bottlenecks ease.
Why should FIT continue?
FIT has worked reasonably well with the average of 4% and a band of +/- 2%.
A reasonable band of 2% on the lower side and 6% on the upper side gives the RBI manoeuvrability for inflation management.
This is especially given the fact that India has many uncontrollable variables, most notably monsoons.
Besides food inflation, fuel inflation is also dependent upon the volatility of crude oil prices.
Also, 4% headline inflation with an upper ceiling of 6% keeps the core inflation (headline inflation minus food and fuel inflation) at an appropriate level.
This is because there is a co-movement of core inflation with the headline inflation and vice versa.
Any increase in the band above 6% will put pressure on the RBI in anchoring inflation expectations.
On the lower side of the band, any inflation rate lower than 2% has the potential risk of the economy entering in a deflationary situation.
Prior to the adoption of FIT, the RBI did not have the exposure in terms of responding to the CPI inflation.
Earlier, WPI was taken as inflation measurement. However, CPI gives a weightage of around 46% to food inflation on which the RBI has no control.
Over the four-year period since FIT adoption, the RBI’s CPI inflation forecasting has been reasonably successful.
RBI has also been effective in anchoring inflation expectation in a three-month and one-year ahead time frame.
What lies ahead?
FIT should not be considered as a statistical measure to balance the risk of inflation alone.
In many ways, it is a barometer of measuring the quality of macroeconomic management particularly in a country where poverty predominates.
What is required is not the change in FIT but an effective fiscal and monetary interface with responsible and functional autonomy to the RBI.
