A to 6% and sometimes even close

A policy which has been an inherent part of most of the developed economies and some developing economies of the world is the inflation targeting policy. To talk about the policy of interest rate cut it is important to understand that being a monetary policy it is under the control of central bank of a country and in our case RBI has been using this as a tool to tackle our only target, inflation, after we decided to opt for inflation targeting back in 2015.We witnessed a historic low consumer price index of 1.5% for the month of June, which is far below our target inflation level of 4% and even below the lower limit of the band of 2-6% which is assumed to be fine in our inflation targeting system.

This was supposed to be a call for RBI to cut interest rate so that inflation shoots up. But, there are several historic evidences which may make us reconsider our decision taken in 2015. The Bank of England was one of the first banks to adopt inflation targeting and this bank, has had a history of failures in achieving its targets by leaps and bounds. But, why? Is it because it has tried to take care of other economic parameters as well like employment and exchange rate? This cannot be the case because no bureaucrat would want to be in a position where he has to explain the authorities the reason of its failure to achieve target it has set himself, every time. USA and Eurozone too show the evidences that inflation targeting isn’t working. The market based inflation expectations of 2016 for these regions clearly showed that long term inflation expectations are sagging, and not meeting the target.Considering the performance of the RBI in this context, it is found revealing in its early days.

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But, the manufacturing sector which is the sector directly under the control of what RBI does, was showing a continuous decline after 2015 when the Index of Indian industrial production was looked into. It was seen that while inflation has been within the target range of 2% to 6% and sometimes even close to 4% but industrial production index was fluctuating upwards and downwards between 2015-2016 and very recently, declining continuously, indicating a poor growth in the manufacturing sector. The data from economic survey 2017 indicated the extremely low industrial production index of 1.

5.The above scenario may make you blame our policymakers who brought such a policy in place at first, and then might also lead us to blame them responsible for not being able to handle the only task they are supposed to, but mind you this might be really early despite the fact that it seems to be already late. Confused? Well, looking into the model on which the policy has been based makes us think that the policymakers were in fact extremely bewildered while adopting it, so much so that they couldn’t see that the inflation targeting policy is completely invalid in our case. Let me prove it step by step.1.

      The model of inflation targetingThe model of inflation targeting is based on Taylor’s Rule which gives a direction to achieving the inflation target. It can be shown by the following equation: Taylor argued if central bank chose nominal interest rate, then it should follow the above equation. i.

e. if  inflation is equal to the target and unemployment rate is equal to the natural rate then central bank should choose interest rate equal to the target interest rate.If inflation is higher, centralbank should increase the nominal interest rate it above the target i*.

this high interest rate will increase unemployment which will lead to further decrease in inflation.2.      Drawbacks which have been completely ignored:First, it is completely based on policymaker’s faith of potential output and unemployment because both the variables are actually unobservable.

Second, this potential level is believed to be subjected to a change by the proponents of the model only, which is not a sound basis of governance. 3.      Prerequisites of the model:That central bank should be able to conduct monetary policy upto some degree of independence. No central bank can be entirely independent of government influence, but it must be free in choosing the instruments to achieve the rate of inflation that the government deems appropriate.

We all know how independent Indian central bank is atlest at present taking into account the demonetization of higher denomination without central bank even having a brink of it. 1.      And comply with this requirement, a second requirement is that a country cannot exhibit symptoms of “fiscal dominance”–that is, fiscal policy considerations cannot dictate monetary policy. Freedom from fiscal dominance implies that government borrowing from the central bank is low or nil, and that domestic financial markets have enough depth to absorb placements of public debt, such as treasury bills.For this all that I need to say is that India.  is currently having a loan over 57 lakh crore from RBI. 2.

      The third requirement for inflation targeting to work is the willingness and ability of the monetary authorities not to target other indicators, such as wages, the level of employment, or the exchange rateNow this was violated the day india chose flexible exchange rate targeting which it chose solely to keep other economic parameters in mind. Now, I would complete with a note that this policy which was devised keeping in mind has not been a very successful one but a its minute picture for india is even worse as the considerations themselves don’t match with india’s situation.So in my view this policy requires a rethinking!


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