Tweaking the inflation targeting mandate

A key focus for the new govt should be to ensure wider consultation in setting inflation target

World over, doubts are being raised about the effectiveness and even relevance of the inflation targeting mandate of central banks. Central banks have faced criticism for failing to correctly judge and predict the interest rate-inflation dynamics during the post-Covid period.

Take the Indian case. The Reserve Bank of India (RBI) kept the interest rates quite low during 2020-21 and 2021-22. Inflation had conspicuously started raising its head by the middle of 2021-22, but was considered transitory by the central bank and ignored. Then, all of a sudden, in May 2022, the RBI began one of the steepest interest rate-raising cycles in recent history.

The repo rate was increased from 4 per cent to 6.5 per cent by February 2023, and rates have been kept at this level since then.

For quite some time now, the markets have been speculating about when the RBI would start reducing interest rates. Many experts view the current real interest rates to be high, discouraging new investments and hurting growth. The arguments circulating suggest that the increase in repo rate has achieved its purpose, and it is time for the RBI to announce a road map for rate cuts. Some advocate that the real interest rates shouldn't be more than 1-1.5 per cent, and question whether consumer price index (CPI) is the right inflation index to target.

They argue that the RBI should take the lead in reducing rates without waiting for the US Fed to do so. On the contrary, there are others who support keeping the rates high to bring the CPI below 4 per cent. Some have even raised the basic doubt of whether the central bank can actually credibly control inflation.

This column examines the need for tweaking the present inflation-targeting mechanism in India, an ILLUSTRATION: BINAY SINHA Go issue that should be prioritised by the new government formed in June.